Last fall and early winter I posted a series of four blogposts (here, here, here, and here) about or related to Ralph Hawtrey as I was trying to gather my thoughts about an essay I wanted to write about Hawtrey as a largely forgotten pioneer of macroeconomics who has received the attention of two recent books by Robert Hetzel and Clara Mattei. After working on and off on the essay in the winter and spring, receiving helpful comments and advice from friends and colleagues, I posted a draft on SSRN.
Hawtrey’s discussion of the fear of inflation refutes the key contentions about Hawtrey made by Hetzel and by Mattei: first, that Hawtrey believed that monetary policy was powerless to increase aggregate demand and stimulate a recovery from the Great Depression (Hetzel), and second that Hawtrey was instrumental in designing a Treasury policy agenda of austerity using deflation and unemployment to crush the aspirations of the British working class for radical change, providing a model emulated by fascists and authoritarians upon coming to power (Mattei).
A slight, non-substantive, revisions of the essay is now being reviewed by SSRN before replacing the current version now available. After some further revisions, the essay will appear later this year as an article in Economic Affairs.
Nobel Laureate T. C. Koopmans wrote one of the most famous economics articles of the twentieth century, “Measurement Without Theory,” a devastating review of an important, and in many ways useful and meritorious, study of business cycles by two of the fathers of empirical business-cycles research, Arthur F. Burns and Wesley C. Mitchell, Measuring Business Cycles. Burns was then the head of the National Bureau of Economic Research, which had been founded by Mitchell, Burns’s mentor, to promote the empirical study and measurement of business cycles. Koopmans, who was then head of the Cowles Commission, another foundation dedicated to the study of business cycles, but with a theoretical, rather than a purely empirical, orientation, explained why attempting to gather empirical facts about business cycles and to measure aspects of business cycles in an atheoretical manner would fail to produce knowledge that useful for trying to understand business cycles as a characteristic feature of modern economic activity, or for devising policies mitigate their undesirable effects.
Koopmans’s review, a rhetorical masterpiece, brilliantly deploying his analytical skill and erudition as a Ph.D. physicist, compared the work of Burns and Mitchell to pre-Newtonian attempts to develop theories of planetary motion through the accumulation of data from planetary observations, largely shut down the program of the National Bureau as a center for business-cycle research, though it has continued to function usefully as a sponsor of a variety of important research efforts on business cycles and other fields of study. Whether the shift in emphasis from atheoretical empirics and data accumulation to theoretical research was a positive development is still controversial, but that discussion is not the point of this post.
All I want to do here is to reproduce a single paragraph from Koopmans’s review in which, without mentioning the Phillips Curve, which had still not been discovered (apologies to Irving Fisher who, almost completely unnoticed, actually discovered it about 30 years before Phillips did), beautifully explains why the Phillips Curve cannot be used as a guide to conducting monetary policy or countercyclical policy of any kind.
[Economic] theories are based on evidence of a different kind than the observations embodied in time series: knowledge of the motives and habits of consumers and of the profit-making objectives of business enterprise, based partly on introspection, partly on interview or on inferences from observed actions of individuals–briefly, a more or less systematized knowledge of man’s behavior and its motives. While much in these theories is incomplete and in need of reformulation and elaboration (particularly in regard to behavior over time under conditions of uncertainty), such theory es we have is an indispensable element in understanding in a quantitative way the formation of economic variables. For according to that theory the relevant economic variables are determined by the simultaneous validity of. an equal number of “structural” equations (of behavior, of law or rule, of technology). The very fact that so many relations are simultaneously valid makes the observation of any one of them difficult, and sometimes even impossible. For any observed regularity between simultaneous and/or successive values of certain variables may have to be ascribed to the validity of several structural equations rather than any one of them. The mere observation of regularities in the interrelations of variables then does not permit us to recognize or to identify behavior equations among such regularities. In the absence of experimentation, such identification is possible, if at all, only if the form of each structural equation is specified, i.e., in particular, if we can indicate the set of variables involved in each equation, and perhaps also the manner in which they are to be combined. In each case, a preliminary study of the system of structural equations held applicable is required to decide whether the specifications regarding any particular equation are sufficiently detailed to permit its identification. Without such identification, measurement of the structural equation involved is not possible, and should therefore not be attempted.
One might object: why should measurement of the behavior equations of consumers, workers, entrepreneurs be necessary? If observed regularities are due to the simultaneous validity of several behavior equations, these regularities will persist as long as each of the underlying (unknown) behavior patterns persists. However, there are important arguments to counter this objection. Sheer scientific curiosity still urges us on to penetrate to the underlying structural equations. This curiosity is reinforced and justified (if you wish) by the awareness that knowledge of the behavior patterns will help in nderstanding or analyzing different situations, for instance, problems of secular trend, or cyclical problems in other countries or periods–in the same way (although one would not expect with the same exactness) in which the law of gravitation explains celestial and terrestrial phenomena alike. This point has particular relevance with regard to the different situations expected to arise in an impending future period of the same country that has been studied. Behavior patterns are subject to change: gradually through changing habits and tastes, urbanization and industrialization; gradually or unevenly through technological change; abruptly through economic policies or the economic effects of political events. While one particular behavior pattern may be deemed fairly stable over a certain period, a much greater risk is involved in assuming that a whole system of structural equations is stable over time. An observed regularity not traced to underlying behavior patterns, institutional rules, and laws of production, is therefore an instrument of unknown reliability. The predictions it yields cannot be qualified with the help even of known trends in behavior or technology. It is of no help whatever in assessing the probable effects of stated economic policies or institutional changes.
There is no sign in the book of an awareness of the problems of determining the identifiability of, and measuring, structural equations as a prerequisite to the practically important types of prediction. Measurable effects of economic actions are scrutinized, to all appearance, in almost complete detachment from any knowledge we may have of the motives of such actions. The movements of economic variables are studied as if they were the eruptions of a mysterious volcano whose boiling caldron can never be penetrated. There is no explicit discussion at all of the problem of prediction, its possibilities and limitations, with or without structural change, although surely the history of the volcano is important primarily as a key to its future activities. There is no discussion whatever as to what bearing the methods used, and the provisional results reached, may have on questions of economic policy.
This, then, is my second argument against the empiricist position: Without resort to theory, in the sense indicated, conclusions relevant to the guidance of economic policies cannot be drawn.
T. C. Koopmans, “Measurement Without Theory,” The Review of Economics and Statistics 29(3): 161-72, pp. 166-67
Clara Mattei, associate professor of economics at the New School for Social Research, recently published a book, The Capital Order: How Economists Invented Austerity and Paved the Way to Fascism, (University of Chicago Press) in which she argues that the fiscal and monetary austerity imposed on Great Britain after World War I to restore the gold standard at the prewar parity of pound to the dollar provided a model for austerity policies imposed by Mussolini in Italy when he took control of the Italian state in the early 1920s. In making her argument, Mattei identifies Hawtrey, Director of Financial Enquiries in the British Treasury for the entire interwar period, as the eminence grise behind the austerity policies implemented by the Treasury and the Bank of England to restore convertibility at the prewar parity.
Mattei’s ideological position is obviously left of center, and her attempt to link British austerity policies during the 1920s with the rise of fascism in Italy furthers her ideological agenda. Although that agenda is not mine, my only interest here is to examine her claim that Hawtrey was the intellectual architect of the austerity policies she deplores. I leave it to others to assess her broader historical claims.
In her introductory chapter, Mattei (p. 10) justifies her attention to Hawtrey, by claiming that his “texts and memoranda . . . would serve as the guidelines for British austerity after World War I,” describing the Treasury officials Sir Basil Blackett and Sir Otto Niemeyer, under whom Hawtrey served, as “working at his side,” as if they were Hawtrey’s subordinates rather than the other way around. At the end of the chapter, Mattei (p. 20) writes: “I was riveted by the evidence of Hawtrey’s persuasion of the other two bureaucrats, and in turn how the two bureaucrats, neither one a trained economist, came to be missionaries in campaigns to export the British austerity agenda to other countries around the globe.” In a later passage (p. 171), she elaborates:
In the face of unrelenting opposition, Niemeyer and Blackett needed solid intellectual grounds to urge the chancellor of the exchequer to move for dear money and drastic cuts in public expenditures. In examining the controllers’ confidential Treasury files—virtually the only direct source of information we have about their economic beliefs—one is struck by the ubiquity and influence of the economist Ralph G. Hawtrey, the primary source of economic knowledge for Blackett and especially for Niemeyer. In fact, there is ample evidence that Hawtreyan economics refined and strengthened the economic stance of the senior Treasury officials, so as to enable the emergence of a full-blown austerity doctrine.
Given her emphasis on the documentary record left by Hawtrey during his nearly three decades as the in-house economist at the Treasury, I would have expected to see more than just the few direct quotations and citations from the voluminous internal memos written by Hawtrey to his Treasury colleagues to which Mattei makes general reference. The references to Hawtrey’s communications with his colleagues provide few specifics, while the more numerous citations to his writings seem to misinterpret, misrepresent or mischaracterize Hawtrey’s theoretical and policy views.
It should also be noted that Mattei’s estimation of Hawtrey’s influence at the Treasury is not shared by other researchers into Hawtrey’s life and career. R. D. C. Black, who wrote an admiring biographical essay on Hawtrey for the British Academy of which Hawtrey became a member in 1935, wrote dismissively of Hawtrey’s influence at the Treasury.
Hawtrey drew up many and varied reports and memoranda on economic and financial matters which are now to be found among the papers of senior Treasury officials of that period, but the impression prevails that they did not receive much attention, and that the Financial Enquiries Branch under Hawtrey was something of a backwater.
R. D. C. Black, “Ralph George Hawtrey, 1879-1975.” In Proceedings of the British Academy, 1977, p. 379.
Susan Howson, in her biographical essay on Hawtrey, believed that Hawtrey was influential eary in his tenure as Director of Financial Enquiries, primarily because of his important role in drafting the financial resolutions for the Genoa Conference of 1922, about which more will be said below, but that his influence declined subsequently. Mattei cites both Black and Howson in her book, but does not engage with their assesment of Hawtrey’s influence at Treasury. Mattei also cites the unpublished doctoral dissertation of Alan Gaukroger on Hawtrey, which focuses specifically on his service as Director of Financial Enquiries at the Treasury, but does not engage with his detailed assement, based on exhaustive reading of relevant Treasury memoranda, of Hawtrey’s influence on his Treasury colleagues and superiors. Here is how Gaukroger characterizes those memoranda:
In the case of Hawtrey, who was to some extent an outsider to the very small and closely knit group of influential policy makers, the written memorandum was his method of attempting to break into, and influence, the powerful central group. . . .
Many of Hawtrey’s memoranda were unsolicited. He produced them because he was critical of some spect of Government policy. In some of these memoranda there is a marked tone of anger. This was particularly apparent during the late 1920s when the United Kingdom had returned to the Gold Standard and Hawtrey believed that the Bank of England was pursuing a foolish and unnecessarily high interest rate policy. At this time, his memoranda, critical of Bank or even Treasury policy, could, for such a mild-mannered man, be quite savage in tone. Often, his memoranda were produced as a result of a specific request. On a very small number of occasions they were produced as a result of a direct request for guidance, or information, from the Chancellor of the Exchequer. At other times Hawtrey prepared a memorandum as a result of a Parliamentary Question. Often a senior colleague wanted support in reparing a memorandum and would seek to use Hawtrey’s expertise, particularly with regard to currency and foreign exchange. Hawtrey would invariably write an unsolicited memorandum after press criticism of Treasury Policy.
A. Gaukroger, “The Director of Financial Enquiries.” Ph.D. Thesis. University of Huddersfield, 2008, pp. 29-32
In criticizing the austerity doctrines and policies of the British Treasury and the Bank of England in the decade after World War I, Mattei mounts a comprehensive attack on Hawtrey’s views (or what she inaccurately represents to be his views) to which she, unlike other researchers, ascribes immense influence. She begins with the decision to restore the gold standard and the subsequent deflationary policy adopted in the1920-22 period to reverse the wartime and postwar inflations, and subsequently to restore the gold standard at the prewar parity of the pound to the dollar ($4.86). Mattei’s overestimation of Hawtrey’s influence is evidenced by her failure even to mention the 1918 interim report of the Cunliffe Commission (headed by the former Governor of the Bank of England Lord Cunliffe) recommending the prompt restoration of the gold standard in as close a form as possible to the prewar gold standard. Although no precise parity was specified, the goal of minimizing the departure from the prewar gold standard (except for not reintroducing a full-bodied gold coinage) made the prewar parity to the dollar, restored in 1919 to its prewar gold parity of $20.67/ounce, the obvious benchmark for restoration.
Her next object of criticism is Hawtrey’s advocacy of deflation in his 1919 article “The Gold Standard,” to reverse, if only partially, the inflation during and after the war that had cut the purchasing power of the pound by roughly 60%. The inflation, especially the postwar inflation, had been deeply unsettling, and there was undoubtedly strong political pressure on the government to halt the inflation. Although opposed to both inflation and deflation, Hawtrey believed that some deflation was needed to achieve stabilization, especially given that the US, which had restored convertibility of the dollar into gold in June 1919, would likely adopt a deflationary policy.
Mattei cites Hawtrey’s approval of the April 1920 increase in Bank rate by the Bank of England to an unprecedented 7% to break the inflationary spiral then underway. Inflation was quickly tamed, but a brutal deflation followed, while Bank rate remained at 7% for more than 12 months before a half a percent cut in April 1922 with further half-percent cuts at bimonthly intervals till the rate was reduced to 3% in July 1922.
Hawtrey’s support for deflation was less categorical and durable than Mattei claims. Prices having risen much faster than wages since the war started, Hawtrey thought that deflation would cause prices to fall before downward pressure on wages started. (See G. C. Peden, The Treasury and British Public Policy 1906-1959, Oxford: Oxford University Press, p. 154.) Once unemployment increased and wages came under significant downward pressure, Hawtrey began to call for easing of the dear-money policy of the Bank. Montague Norman, Governor of the Bank of England, aware of Hawtrey’s criticisms of Bank of England policy, shared his annoyance with Hawtrey in a letter to his counterpart at the Federal Reserve, Benjamin Strong, mentioning criticism from “a ‘leading light’ of the Treasury [who] made it his particular business to quarrel with the policy of the Treasury and the Bank of England.” (See G. C. Peden, Id. pp. 155-56.) Hawtrey later articulated the basis for his criticism.
In 1920 it was justifiable to keep up Bank rate so long as there was any uncertainty whether inflation had been successfully checked. But even in the late summer of 1920 there was no real doubt that this was so, and by November 1920, it was abundantly clear that the danger was in the opposite direction, and was that of excessive deflation.
Hawtrey, A Century of Bank Rate, London: Longmans, Green and Co., 1938, p. 133.
Mattei further attacks Hawtrey for his central role in the Genoa Conference of 1922, which, besides resolutions on other topics of international concern, adopted resolutions aimed at restoring the international gold standard. As early as in his 1919 article on the gold standard and in his important book Currency and Credit of the same year, Hawtrey was warning urgently that restoring the gold standard could cause severe–possibly disastrous–deflation unless countries rejoining the gold standard cooperated to moderate their demand for gold reserves when setting fixed parities between their currencies and gold.
Hawtrey therefore proposed that countries other than the US and Britain rejoin the gold standard by discharging their obligations in dollars or pound sterling, which were either (in the case of the dollar) already convertible into gold, or (in the case of sterling) likely to be convertible in the future. By freeing national central banks from the need to hold actual gold reserves to discharge their obligations, the Genoa proposals aimed to limit the international demand for gold, thereby moderating or eliminating the deflationary pressure otherwise entailed by restoring the gold standard. Additionally, the resulting demand by central banks to hold sterling-denominated liabilities would ease the pressure on the British balance of payments, thereby making room for the Bank of England to reduce Bank rate.
Ignoring Hawtrey’s anti-deflationary intent in drafting those resolution, Mattei focuses on the legal independence for central banks proposed by the resolutions, intended to insulate them from demands by national governments to print money to fund fiscal deficits, money printing by governments or by banks under government pressure to do so, having been, historically, a primary cause of inflation. Mattei further misrepresents Hawtrey’s call for monetary management to avoid the likely deflationary consequences of an unmanaged restoration of the prewar gold standard as evidence that Hawtrey desired to impose an even more draconian austerity on British workers than an unmanaged restoration of the gold standard would have imposed, thereby imputing to Hawtrey an intention precisely the opposite of what he meant to accomplish.
Mattei equates Hawtrey’s support for central-bank independence in the Genoa Resolutions with hostility to democracy. Quoting from Hawtrey’s 1925 article “Currency and Public Administration,” which, she suggests, betrays a technocratic and anti-democratic mindset that he shared with contemporary Italian theoreticians of fascism, Mattei seizes on the following passage:
The central bank is free to follow the precept: “never explain; never regret; never apologize.” It need make no statement of policy. Critics may rage for nine days, but in face of the silence imposed by tradition they do not keep it up.”
Hawtrey, “Currency and Public Administration” Public Administration 3(3):232-45, 243
Mattei subjects the elitist tone of Hawtrey’s defense of central bank independence to withering criticism, a criticism echoed by her ideological opposite Milton Friedman, but she neglects to quote an important explanatory passage.
The public interest in the broadest sense is profoundly affected by currency administration. Those who deprecate criticism fear an ill-judged pressure at critical times. Experience shows that, whenever an expansion of credit is developing to excess, a formidable opposition arises in the trading world to an increase in bank rate. When on the other hand, business is in a state of depression, no one minds what happens to bank rate. The influence of outside pressure is, therefore, just the contrary to what is required.
Perhaps that is so, because criticism is confined to financial and trading circles. When credits is expanding, traders want to borrow, and resent any measures which makes borrowing more difficult or more expensive. When business is depressed, they do not want to borrow. In neither case are they impelled to look beyond their own affairs to the effect of credit on the public interest.
Id.
It is interesting that Hawtrey would have written as he did in 1925 given his own recent experience in criticizing the dear money policy generally followed by the Bank of England since 1921 when the Bank of England steadfastly refused to lower Bank rate despite his own repeated pleas for rate reductions and criticisms of the Bank’s refusal to respond to those pleas.
In his lengthy and insightful doctoral dissertation about Hawtrey’s tenure at the Treasury, Alan Gaukroger, relying far more intensively and extensively than Mattei on the documentary record of Hawtrey’s tenure, discusses a Treasury Memorandum written by Hawtrey on December 5, 1925 soon after Bank of England raised Bank rate back to 5% after briefly reducing it to 4% immediately after restoration of the prewar parity with dollar in April.
The raising of the Bank rate to 5% is nothing less than a national disaster. That dear money causes unemployment is a proposition which ought not to admit of dispute. Not only is it the generally accepted opinion of theoretical economists, but it was well recognised by practical financiers and men of business before economists paid much attention to it.
Gaukroger, p. 194
Gaukroger (p. 193) also reports, relying on a recorded interview of Hawtrey conducted by Alexander Cairncross in 1965, that upon hearing the news that Bank rate had been raised back to 5%, Hawtrey went directly to Niemeyer’s office to express his fury at the news he had just heard, only to find, after he had begun denouncing the increase, that Montagu Norman himself had been seated in Niemeyer’s office behind the door he had just opened. Direct communication between Hawtrey and Norman never resumed.
Gaukroger also reports that Hawtrey’s view was dismissed not only by the Bank of England but by his superior Otto Niemeyer and by Niemeyer’s deputy Sir Frederick Leith-Ross, who invidiously compared Hawtrey in opposing an increase in Bank rate to Rudolf Havenstein, President of the German Reichsbank during the German hyperinflation of 1923.
As already mentioned, Mattei accuses Hawtrey of having harbored a deflationary bias owing to a belief that a credit economy is inherently predisposed toward inflation, a tendency that must be counteracted by restrictive monetary policy.
Mattei’s accusation of deflationary bias rests on a misunderstanding of Hawtrey’s monetary theory. In Hawtrey’s theory, if banks create too much credit, the result is inflation; if they create too little, the result is deflation. No endogenous mechanism keeps credit creation by banks on a stable non-inflationary, non-deflationary path. Once inflation or deflation sets in, a cumulative process leads to continuing, even accelerating, inflation or deflation. To achieve stability, an exogenous stabilizing mechanism, like a metallic standard or a central bank, is needed to constrain or stimulate, albeit imperfectly, credit creation by the banking system. It was only in the special conditions after World War I and the collapse of the prewar gold standard, which had been centered in London, that Hawtrey believed a limited deflation would be useful in pursuing the generally accepted goal of restoring the prewar gold standard. But the postwar deflation was far more extreme than the deflation contemplated, much less endorsed, by Hawtrey.
Mattei infers from Hawtrey’s support for deflation to reverse the postwar inflation, that he regarded inflation as a greater and more dangerous threat than inflation, without acknowledging that he regarded the 1920-22 deflation as excessive and unjustified. She also cites his endorsement of restoring convertibility of the pound at the prewar ($4.86) parity against the dollar, despite the deflationary implications of that restoration, as further evidence of Hawtrey’s approval of deflation. But Mattei ignores Hawtrey’s repeated arguments that, given the high rate of unemployment in Britain, there was ample room, even after restoration of the prewar parity, for the Bank of England to have reduced Bank rate to promote increased output and employment.
The advance of Bank rate to 5% in March 1925 supervened on a condition of things which promised to bring the pound sterling to par with the dollar without any effort at all. Credit was expanding and the price level in the United States, which may be taken as indicating the price level in terms of gold, was rising. This expansive tendency came abruptly to an end. The rediscount rate, it is true, was raised in New York, but only to 3.5%, and till 1928 the American Federal Reserve Bank adhered to moderate rediscount rates and a policy of credit relaxation. The deflationary tendency in the gold standard world was due to the continuance of dear money in London. In British industry unemployment remained practically undiminished.
Hawtrey, A Century of Bank Rate, London: Longmans, Green and Co., 1938, pp. 137-38
While Mattei acknowledges that Hawtrey favored easing monetary policy after the restoration of the prewar parity, she minimizes its significance by citing Hawtrey’s recommendation to increase Bank rate in 1939 from the 2% rate at which it had been pegged since July 1932. But by 1940 British inflation had risen above 10%, substantiating Hawtrey’s fear, with Britain about to enter into World War II, of renewed inflation.
Mattei even imputes a sinister motivation to Hawtrey’s opposition to inflation, suggesting that he blamed inflation on the moral turpitude of workers lacking the self-discipline to save any of their incomes rather than squander it all on wasteful purchases of alcohol and tobacco, in contrast to the virtuous habits of the bourgeoisie and the upper classes who saved a substantial portion of their incomes. In doing so, Mattei, in yet another misunderstanding and mischaracterization, mistakenly attributes an over-consumption theory of inflation to Hawtrey. The consumption habits of the working class are irrelevant to Hawtrey’s theory of income and prices in which total income is determined solely by the amount of credit created by the banking system.
If substantial idle resources are available, a reduced lending rate encourages retail and wholesale businesses and traders to increase their holdings of inventories by increasing orders to manufacturers who then increase output, thereby generating increased income which, in turn, leads to increased purchases of consumer and capital goods. The increase in output and income causes a further increase the desired holdings of inventories by businesses and traders, initiating a further round of increases in orders to manufacturers so that further increases in output and income are constrained by the limits of capacity, whereupon further reductions in lending rates would cause inflation rather than increased output.
While the composition of output between investment goods and consumption goods is governed, in Hawtrey’s theory, by the savings habits of households, the level of total output and income and the rate of inflation or deflation are determined entirely by the availability of credit. It was precisely on this theoretical basis that Hawtrey denied that increased public spending would increase output and employment during a depression unless that spending was financed by credit expansion (money creation); if financed by taxation or by borrowing, the public spending would simply reduce private spending by an equal amount. Mattei recognized the point in connection with public spending in her discussion of Hawtrey’s famous articulation of the Treasury View (see Hawtrey, “Public Expenditure and the Demand for Labour,”), but failed to recognize the same theoretical argument in the context of spending on consumption versus spending on investment.
I close this post with a quotation from Hawtrey’s Trade Depression and the Way Out, 2nd edition, a brilliant exposition of his monetary theory and its application to the problem of inadequate aggregate demand, a problem, as Keynes himself admitted, that he dealt with before Keynes had addressed it. I choose a passage from the last section, entitled “The Fear of Inflation,” of the penultimate chapter. Evidently, Mattei has not studied this book (which she does not cite or refer to). Otherwise, I cannot imagine how she could have written about Hawtrey in her book in the way that she did.
The fears that efforts to expand credit will be defeated in one way or anotherby the pessimism of traders are not wholly irrational. But that pessimism is no more than an obstacle to be overcome. And the much more usual view is that inflationary measures take effect only too easily
The real obstacle to measures of credit expansion is not the fear that they will not be effective, but the fear that they will. [author’s emphasis]
Yet what can be more irrational that that fear? The term inflation is very loosely used; sometimes it means any expansion of the currency or of bank credit, or any such expansion not covered by metallic reserves; sometimes it means an issue of currency by way of advances to the Government or else an issue backed by Government securities. But whatever the precise measures classed as inflationary may be, their common characteristic and the sole source of danger attributed to them is that they tend to bring about an enlargement of demand and a consequent rise of prices. And an enlargement of demand is the essential condition of recovery. To warnthe world against inflation is to warn it against economic revival.
If the economic system of the world had adjusted itself to the existing price level, there would be good reason to object to a renewed change. Inflation is rightly condemned, because it means an arbitrary change in the value of money in terms of wealth. But deflation equally means an arbitrary change in the value of money. The reason why inflation is more condemned and feared is that it is apt to appear convenient and attractive to financiers in difficulties. The consequences of deflation are so disastrous and the difficulties of carrying it out so great that no one thinks it necessary to attach any stigma to it. And since from time to time deflation has to be applied as a corrective of inflation, it is given the status of an austere and painful virtue.
But essentially it is not a virtue at all, and when it is wantonly imposed on the world, not as a corrective of inflation but as a departure from a pre-existing state of equilibrium, it ought to be regarded as a crime against humanity. [my emphasis]
Just as deflation may be needed as a corrective to an inflation to which the economic system has not adjusted itself, so at the present time inflation is needed as a corrective to deflation. If the monetary affairs of the world were wisely governed, both inflation and deflation would be avoided, or at any rate quickly corrected in their initial stages. Perhaps the ideal of monetary stability will be achieved in the future. But to start stereotyping conditions in which prices are utterly out of equilibrium with wages and debts, and with one another, would be to start the new polcy under impossible conditions.
The dread of inflation has been greatly accentuated by the experiences of the years following the war, when so many countries found that the monetary situation got completely out of control. The vicisous circle of inflation gained such power that it wrecked both the tax system and the investment market; it cut off all the normal resources for meeting public expenditure, and left Governments to subsist on issues of paper money. No country would willingly endure such a situation.
But that kind of monetary collapse does not come easily or suddenly. There is, I believe, no case in history in which inflation has got out of hand in less that three years. [author’s emphasis] . . .
The fear that one slip from parity means a fall into the abyss is entirely without foundation. Especially is that so when deflation is raging. The first impact of a monetary expansion is then felt rather in increased output than in higher prices. It is only when industry has become fully employed that the vicious circle of inflation is joined and prices begin to rise.
In my previous post, I explained how the real-bills doctrine originally espoused by Adam Smith was later misunderstood and misapplied as a policy guide for central banking, not, as Smith understood it, as a guide for individual fractional-reserve banks. In his recent book on the history of the Federal Reserve, Robert Hetzel recounts how the Federal Reserve was founded, and to a large extent guided in its early years, by believers in the real-bills doctrine. On top of their misunderstanding of what the real-bills doctrine really meant, they also misunderstood the transformation of the international monetary system from the classical gold standard that had been in effect as an international system from the early 1870s to the outbreak of World War I. Before World War I, no central bank, even the Bank of England, dominant central bank at the time, could determine the international price level shared by all countries on the gold standard. But by the early 1920s, the Federal Reserve System, after huge wartime and postwar gold inflows, held almost half of the world’s gold reserves. Its gold holdings empowered the Fed to control the value of gold, and thereby the price level, not only for itself but for all the other countries rejoining the restored gold standard during the 1920s.
All of this was understood by Hawtrey in 1919 when he first warned that restoring the gold standard after the war could cause catastrophic deflation unless the countries restoring the gold standard agreed to restrain their demands for gold. The cooperation, while informal and imperfect, did moderate the increased demand for gold as over 30 countries rejoined the gold standard in the 1920s until the cooperation broke down in 1928.
Unlike most other Monetarists, especially Milton Friedman and his followers, whose explanatory focus was almost entirely on the US quantity of money rather than on the international monetary conditions resulting from the fraught attempt to restore the international gold standard, Hetzel acknowledges Hawtrey’s contributions and his understanding of the confluence of forces that led to a downturn in the summer of 1929 followed by a stock-market crash in October.
Recounting events during the 1920s and the early stages of the Great Depression, Hetzel mentions or quotes Hawtrey a number of times, for example, crediting (p. 100) both Hawtrey and Gustav Cassel, for “predicting that a return to the gold standard as it existed prior to World War I would destabilize Europe through deflation.” Discussing the Fed’s exaggerated concerns about the inflationary consequences of stock-market spectulation, Hetzel (p. 136) quotes Hawtrey’s remark that the Fed’s dear-money policy, aiming to curb stock-market speculation “stopped speculation by stopping prosperity.” Hetzel (p. 142) also quotes Hawtrey approvingly about the importance of keeping value of money stable and the futility of urging monetary authorities to stabilize the value of money if they believe themselves incapable of doing so. Later (p. 156), Hetzel, calling Hawtrey a lone voice (thereby ignoring Cassel), quotes Hawtrey’s scathing criticism of the monetary authorities for their slow response to the sudden onset of rapid deflation in late 1929 and early 1930, including his remark: “Deflation may become so intense that it is difficult to induce traders to borrow on any terms, and that in that event the only remedy is the purchase of securities by the central bank with a view to directly increase the supply of money.”
In Chapter 9 (entitled “The Great Contraction” in a nod to the corresponding chapter in A Monetary History of the United States by Friedman and Schwartz), Hetzel understandably focuses on Federal Reserve policy. Friedman insisted that the Great Contraction started as a normal business-cycle downturn caused by Fed tightening to quell stock-market speculation that was needlessly exacerbated by the Fed’s failure to stop a collapse of the US money stock precipitated by a series of bank failures in 1930, and was then transmitted to the rest of the world through the fixed-exchange-rate regime of the restored gold standard. Unlike Friedman Hetzel acknowledges the essential role of the gold standard in not only propagating, but in causing, the Great Depression.
But Hetzel leaves the seriously mistaken impression that the international causes and dimensions of the Great Depression (as opposed to the US-centered account advanced by Friedman) was neither known nor understood until the recent research undertaken by such economists as Barry Eichengreen, Peter Temin, Douglas Irwin, Clark Johnson, and Scott Sumner, decades after publication of the Monetary History. What Hetzel leaves unsaid is that the recent work he cites largely rediscoveed the contemporaneous work of Hawtrey and Cassel. While recent research provides further, and perhaps more sophisticated, quantitative confirmation of the Hawtrey-Cassel monetary explanation of the Great Depression, it adds little, if anything, to their broad and deep analytical and historical account of the downward deflationary spiral from 1929 to 1933 and its causes.
In section 9.11 (with the heading “Why Did Learning Prove Impossible?”) Hetzel (p. 187) actually quotes a lengthy passage from Hawtrey (1932, pp. 204-05) describing the widely held view that the stock-market crash and subsequent downturn were the result of a bursting speculative bubble that had been encouraged and sustained by easy-money policies of the Fed and the loose lending practices of the banking system. It was of course a view that Hawtrey rejected, but was quoted by Hetzel to show that contemporary opinion during the Great Depression viewed easy monetary policy as both the cause of the crash and Great Depression, and as powerless to prevent or reverse the downward spiral that followed the bust.
Although Hetzel is familiar enough with Hawtrey’s writings to know that he believed that the Great Depression had been caused by misguided monetary stringency, Hetzel is perplexed by the long failure to recognize that the Great Depression was caused by mistaken monetary policy. Hetzel (p. 189) quotes Friedman’s solution to the puzzle:
It was believed [in the Depression] . . . that monetary policy had been tried and had been found wanting. In part that view reflected the natural tendency for the monetary authorities to blame other forces for the terrible economic events that were occurring. The people who run monetary policy are human beings, even as you and I, and a common human characteristic is that if anything bad happens it is somebody else’s fault.
Friedman, The Counter-revolution in Monetary Theory. London: Institute for Economic Affairs, p. 12.
To which Hetzel, as if totally unaware of Hawtrey and Cassel, adds: “Nevertheless, no one even outside the Fed [my emphasis] mounted a sustained, effective attack on monetary policy as uniformly contractionary in the Depression.”
Apparently further searching for a solution, Hetzel in Chapter twelve (“Contemporary Critics in the Depression”), provides a general overview of contemporary opinion about the causes of the Depression, focusing on 14 economists—all Americans, except for Joseph Schumpeter (arriving at Harvard in 1932), Gottfried Haberler (arriving at Harvard in 1936), Hawtrey and Cassel. Although acknowledging the difficulty of applying the quantity theory to a gold-standard monetary regime, especially when international in scope, Hetzel classifies them either as proponents or opponents of the quantity theory. Remarkably, Hetzel includes Hawtrey among those quantity theorists who “lacked a theory attributing money to the behavior of the Fed rather than to the commercial banking system” and who “lacked a monetary explanation of the Depression highlighting the role of the Fed as opposed to the maladjustment of relative prices.” Only one economist, Laughlin Currie, did not, in Hetzel’s view, lack those two theories.
Hetzel then briefly describes the views of each of the 14 economists: first opponents and then proponents of the quantity theory. He begins his summary of Hawtrey’s views with a favorable assessment of Hawtrey’s repeated warnings as early as 1919 that, unless the gold standard were restored in a way that did not substantially increase the demand for gold, a severe deflation would result.
Despite having already included Hawtrey among those lacking “a theory attributing money to the behavior of the Fed rather than to the commercial banking system,” Hetzel (p. 281-82) credits Hawtrey with having “almost alone among his contemporaries advanced the idea that central banks can create money,” quoting from Hawtrey’s The Art of Central Banking.
Now the central bank has the power of creating money. If it chooses to buy assets of any kind, it assumes corresponding liabilities and its liabilities, whether notes or deposits, are money. . . . When they [central banks] buy, they create money, and place it in the hands of the sellers. There must ultimately be a limit to the amount of money that the sellers will hold idle, and it follows that by this process the vicious cycle of deflation can always be broken, however great the stagnation of business and the reluctance of borrowers may be.
Hawtrey, The Art of Central Banking: London: Frank Cass, 1932 [1962], p. 172
Having already quoted Hawtrey’s explicit assertion that central banks can create money, Hetzel struggles to justify classifying Hawtrey among those denying that central banks can do so, by quoting later statements that, according to Hetzel, show that Hawtrey doubted that central banks could cause a recovery from depression, and “accepted the . . . view that central banks had tried to stimulate the economy, and . . . no longer mentioned the idea of central banks creating money.”
Efforts have been made over and over again to induce that expansion of demand which is the essential condition of a revival of activity. In the United States, particularly, cheap money, open-market purchases, mounting cash reserves, public works, budget deficits . . . in fact the whole apparatus of inflation has been applied, and inflation has not supervened.
Hawtrey, “The Credit Deadlock” in A. D. Gayer, ed., The Lessons of Monetary Experience, New York: Farrar & Rhinehart, p. 141.
Hetzel here confuses the two distinct and different deficiencies supposedly shared by quantity theorists other than Laughlin Currie: “[lack] of a theory attributing money to the . . . Fed rather than to the commercial banking system” and “[lack] of a monetary explanation of the Depression highlighting the role of the Fed as opposed to the maladjustment of relative prices.” Explicitly mentioning open-market purchases, Hawtrey obviously did not withdraw the attribution of money to the behavior of the Fed. It’s true that he questioned whether the increase in the money stock resulting from open-market purchases had been effective, but that would relate only to Hetzel’s second criterion–lack of a monetary explanation of the Depression highlighting the role of the Fed as opposed to the maladjustment of relative prices—not the first.
But even the relevance of the second criterion to Hawtrey is dubious, because Hawtrey explained both the monetary origins of the Depression and the ineffectiveness of the monetary response to the downturn, namely the monetary response having been delayed until the onset of a credit deadlock. The possibility of a credit deadlock doesn’t negate the underlying monetary theory of the Depression; it only suggests an explanation of why the delayed monetary expansion didn’t trigger a recovery as strong as a prompt expansion would have.
Turning to Hawtrey’s discussion of the brief, but powerful, revival that began almost immediately after FDR suspended the gold standard and raised the dollar gold price (i.e., direct monetary stimulus) upon taking office, Hetzel (Id.) misrepresents Hawtrey as saying that the problem was pessimism not contractionary monetary policy; Hawtrey actually attributed the weakening of the recovery to “an all-round increase of costs” following enactment of the National Industrial Recovery Act, that dissipated “expectations of profit on which the movement had been built.” In modern terminology it would be described as a negative supply-side shock.
In a further misrepresentation, Hetzel writes (p. 282), “despite the isolated reference above to ‘creating money,’ Hawtrey understood the central bank as operating through its influence on financial intermediation, with the corollary that in depression a lack of demand for funds would limit the ability of the central bank to stimulate the economy.” Insofar as that reference was isolated, the isolation was due to Hetzel’s selectivity, not Hawtrey’s understanding of the capacity of a central bank. Hawtrey undoubtedly wrote more extensively about the intermediation channel of monetary policy than about open-market purchases, inasmuch as it was through the intermediation channel that, historically, monetary policy had operated. But as early as 1925, Hawtrey wrote in his paper “Public Expenditure and the Demand for Labour”:
It is conceivable that . . . a low bank rate by itself might be found to be an insufficient restorative. But the effect of a low bank rate can be reinforced by purchase of securities on the part of the central bank in the open market.
Although Hawtrey was pessimistic that a low bank rate could counter a credit deadlock, he never denied the efficacy of open-market purchases. Hetzel cites the first (1931) edition of Hawtrey’s Trade Depression and the Way Out, to support his contention that “Hawtrey (1931, 24) believed that in the Depression ‘cheap money’ failed to revive the economy.” In the cited passage, Hawtrey observed that between 1844 and 1924 Bank rate had never fallen below 2% while in 1930 the New York Fed discount rate fell to 2.5% in June 1930, to 2% in December and to 1.5% in May 1931.
Apparently, Hetzel neglected to read the passage (pp. 30-31) (though he later quotes a passage on p. 32) in the next chapter (entitled “Deadlock in the Credit Market”), or he would not have cited the passage on p. 24 to show that Hawtrey denied that monetary policy could counter the Depression.
A moderate trade depression can be cured by cheap money. The cure will be prompter if a low Bank rate is reinforced by purchases of securities in the open market by the Central Bank. But so long as the depression is moderate, low rates will of themselves suffice to stimulate borrowing.
On the other hand, if the depression is very severe, enterprise will be killed. It is possible that no rate of interest, however low, will tempt dealers to buy goods. Even lending money without interest would not help if the borrower anticipated a loss on every conceivable use . . . of the money. In that case the purchase of securities by the Central Bank, which is otherwise no more than a useful reinforcement of the low Bank rate, hastening the progress of revival, becomes an essential condition of the revival beginning at all. By buying securities the Central Bank creates money [my emphasis], which appears in the form of deposits credited to the banks whose customers have sold the securities. The banks can thus be flooded with idle money, and given . . . powerful inducement to find additional borrowers.
Something like this situation occurred in the years 1894-96. The trade reaction which began after 1891 was disastrously aggravated by the American crisis of 1893. Enterprise seemed . . . absolutely dead. Bank rate was reduced to 2% in February 1894, and remained continuously at that rate for 2.5 years.
The Bank of England received unprecedented quantities of gold, and yet added to its holdings of Government securities. Its deposits rose to a substantially higher total than was ever reached either before or after, till the outbreak of war in 1914. Nevertheless, revival was slow. The fall of prices was not stopped till 1896. But by that time the unemployment percentage, which had exceeded 10% in the winter of 1893, had fallen to 3.3%.
Hawtrey, Trade Depression and the Way Out. London: Longmans, Green and Company, 1931.
This passage was likely written in mid-1931, the first edition having been published in September 1931. In the second edition published two years later, Hawtrey elaborated on the conditions in 1931 discussed in the first edition. Describing the context of the monetary policy of the Bank of England in 1930, Hawtrey wrote:
For some time the gold situation had been a source of anxiety in London. The inflow of “distress gold” was only a stop-gap defence against the apparently limitless demands of France and the United States. When it failed, and the country lost £20,000,000 of gold in three months, the Bank resorted to restrictive measures.
Bank rate was not raised, but the Government securities in the Banking Department were reduced from £52,000,000 in the middle of January 1931 to £28,000,000 at the end of March. That was the lowest figure since August 1928. The 3% bank rate became “effective,” the market rate on 3-months bills rising above 2.5%. Here was a restrictive open market policy, designed to curtail the amount of idle money in the banking system.
Between May 1930 and January 1931, the drain of gold to France and the United States had not caused any active measures of credit restriction. Even in that period credit relaxation had been less consistent and whole-hearted than it might have been. In the years 1894-96 the 2% bank rate was almost continuously ineffective, the market rate in 1895 averaging less than 1%. In 1930 the market rate never fell below 2%.
So, notwithstanding Hetzel’s suggestion to contrary, Hawtrey clearly did not believe that the failure of easy-money policy to promote a recovery in 1930-31 showed that monetary policy is necessarily ineffective in a deep depression; it showed that the open-market purchases of central banks had been too timid. Hawtrey made this point explicitly in the second edition (1933, p. 141) of Trade Depression and the Way Out:
When . . . expanding currency and expanding bank deposits do not bring revival, it is sometimes contended that it is no use creating additional credit, because it will not circulate, but will merely be added to the idle balances. And without doubt it ought not to be taken for granted that every addition to the volume of bank balances will necessarily and automatically be accompanied by a proportional addition to demand.
But people do not have an unlimited desire to hold idle balances. Because they already hold more than usual, it does not follow that they are willing to hold more still. And if in the first instance a credit expansion seems to do no more than swell balances without increasing demand, further expansion is bound ultimately to reach a point at which demand responds.
Trying to bolster his argument that Hawtrey conceded the inability of monetary policy to promote recovery from the Depression, Hetzel quotes from Hawtrey’s writings in 1937 and 1938. In his 1937 paper on “The Credit Deadlock,” Hawtrey considered the Fisher equation breaking down the nominal rate of interest into a real rate of interest (corresponding to the expected real rate of return on capital) and expected inflation. Hawtrey explored the theoretical possibility that agents’ expectations could become so pessimistic that the expected rate of deflation would exceed the expected rate of return on capital, so that holding money became more profitable than any capital investment; no investments would be forthcoming in such an economy, which would then descend into the downward deflationary spiral that Hawtrey called a credit deadlock.
In those circumstances, monetary policy couldn’t break the credit deadlock unless the pessimistic expectations preventing capital investments from being made were dispelled. In his gloss on the Fisher equation, a foundational proposition of monetary theory, Hawtrey didn’t deny that a central bank could increase the quantity of money via open-market operations; he questioned whether increasing the quantity of money could sufficiently increase spending and output to restore full employment if pessimistic expectations were not dispelled. Hawtrey’s argument was purely theoretical, but he believed it at least possible that the weak recovery from the Great Depression in the 1930s, even after abandonment of the gold standard and the widespread shift to easy money, had been dampened by entrepreneurial pessimism.
Hetzel also quotes two passages from Hawtrey’s 1938 volume A Century of Bank Rate to show that Hawtrey believed easy money was incapable of inducing increased investment spending and expanded output by business once pessimism and credit deadlock took hold. But those passages refer only to the inefficacy of reductions in bank rate, not of open-market purchases.
Hetzel (p. 283-84) then turns to a broad summary criticism of Hawtrey’s view of the Great Depression.
With no conception of the price system as the organizing principle behind the behavior of the economy, economists invented disequilibrium theories in which the psychology of businessmen and investors (herd behavior) powered cyclical fluctuations. The concept of the central bank causing recessions by interfering with the price system lay only in the future. Initially, Hawtrey found encouraging the Fed’s experiment in the 1920s with open market operations and economic stabilization. By the time Hawtrey wrote in 1938, it appeared evident that the experiment had failed.
Hetzel again mischaracterizes Hawtrey who certainly did not lack a conception of the price system as the organizing principle behind the behavior of the economy, and, unless Hetzel is prepared to repudiate the Fisher equation and the critical role it assigns to expectations of future prices as an explanation of macroeconomic fluctuations, it is hard to understand how the pejorative references psychology and herd behavior have any relevance to Hawtrey. And Hetzel’s suggestion that Hawtrey did not hold central banks responsible for recessions after Hetzel had earlier (p. 136) quoted Hawtrey’s statement that dear money had stopped speculation by stopping prosperity seems puzzling indeed.
Offering faint praise to Hawtrey, Hetzel calls him “especially interesting because of his deep and sophisticated knowledge of central banking,” whose “failure to understand the Great Depression as caused by an unremittingly contractionary monetary policy [is also] especially interesting.” Unfortunately, the only failure of understanding I can find in that sentence is Hetzel’s.
Hetzel concludes his summary of Hawtrey’s contribution to the understanding of the Great Depression with the observation that correction of the misperception that, in the Great Depression, a policy of easy money by the Fed had failed lay in the distant monetarist future. That dismissive observation about Hawtrey’s contribution is a misperception whose corretion I hope does not lie in the distant future.
Robert Hetzel, a distinguished historian of monetary theory and of monetary institutions, deployed his expertise in both fields in his recent The Federal Reserve: A New History. Hetzel’s theoretical point departure is that the creation of the Federal Reserve System in 1913 effectively replaced the pre-World War I gold standard, in which the value of the dollar was determined by the value of gold into which a dollar was convertible at a fixed rate, with a fiat-money system. The replacement did not happen immediately upon creation of the Fed; it took place during World War I as the international gold standard collapsed with all belligerent countries suspending the convertibility of their currencies into gold, to allow the mobilization of gold to finance imports of food and war materials. As a result, huge amounts of gold flowed into the US, where of much of those imports originated, and continued after the war when much of the imports required for European reconstruction also originated there, with the US freely supplying dollars in exchange for gold at the fixed price at which the dollar was convertible into gold, causing continued postwar inflation beyond the wartime inflation.
Holding more than half the world’s total stock of monetary gold reserves by 1920, the US could determine the value of gold at any point (within a wide range) of its own choosing. The value of the dollar was therefore no longer constrained by the value of gold, as it had been under the prewar gold standard, because the value of gold was now controlled by the Federal Reserve. That fundamental change was widely acknowledged at the time by economists like Keynes, Fisher, Robertson, Mises, and Hawtrey. But the Fed had little understanding of how to exercise that power. Hetzel explains the mechanisms whereby the power could be exercised, and the large gaps and errors in the Fed’s grasp of how to deploy the mechanisms. The mechanisms were a) setting an interest rate at which to lend reserves (by rediscounting commercial bank assets offered as collateral) to the banking system, and b) buying or selling government securities and other instruments like commercial paper (open-market operations) whereby reserves could be injected into, or withdrawn from, the banking system.
In discussing how the Fed could control the price level after World War I, Hetzel emphasizes the confusion sewed by the real-bills doctrine which provided the conceptual framework for the architects of the Federal Reserve and many of its early officials. Hetzel is not the first to identify the real-bills doctrine as a key conceptual error that contributed to the abysmal policy mistakes of the Federal Reserve before and during the Great Depression. The real-bills doctrine has long been a bete noire of Chicago School economists, (see for example the recent book by Thomas Humphrey and Richard Timberlake, Gold, the Real Bills Doctrine and the Fed), but Chicago School economists since Milton Friedman’s teacher Lloyd Mints have misunderstood both the doctrine (though not in the same way as those they criticize) because they adopt a naive view of the quantity theory the prevents them from understanding how the gold standard actually worked.
Long and widely misunderstood, the real-bills doctrine was first articulated by Adam Smith. But, as I showed in a 1992 paper (reprinted as Chapter 4 of my recent Studies in the History of Monetary Theory), Smith conceived the doctrine as a rule of thumb to be followed by individual banks to ensure that they had sufficient liquidity to meet demands for redemption of their liabilities (banknotes and deposits) should the demand for those liabilities decline. Because individual banks have no responsibility, beyond the obligation to keep their redemption commitments, for maintaining the value of their liabilities, Smith’s version of the real-bills doctrine was orthogonal to the policy question of how a central bank should discharge a mandate to keep the general price level reasonably stable.
Not until two decades after publication of Smith’s great work, during the Napoleonic Wars that confusion arose about what the real-bills doctrine actually means. After convertibility of the British pound into gold was suspended in 1797 owing to fear of a possible French invasion, the pound fell to a discount against gold, causing a general increase in British prices. The persistent discount of the pound against gold was widely blamed on an overissue of banknotes by the Bank of England (whose notes had been made legal tender to discharge debts after their convertibility into gold had been suspended. The Bank Directors responded to charges of overissue by asserting that they had strictly followed Smith’s maxim of lending only on the security of real bills of short duration. Their defense was a misunderstanding of Smith’s doctrine, which concerned the conduct of a bank obligated to redeem its liabilities in terms of an asset (presumably gold or silver) whose supply it could not control, whereas the Bank of England was then under no legal obligation to redeem its banknotes in terms of any outside asset.
Although their response misrepresented Smith’s doctrine, that misrepresentation soon became deeply imbedded in the literature on money and banking. Few commentators grasped the distinction between the doctrine applied to individual banks and the doctrine applied to the system as a whole or to a central bank issuing a currency whose value it can control.
The Bank Directors argued that because they scrupulously followed the real-bills doctrine, an overissue of banknotes was not possible. The discount against gold must therefore have been occasioned by some exogenous cause beyond the Bank’s control. This claim could have been true only in part. Even if the Bank did not issue more banknotes than it would have had convertibility not been suspended, so that the discount of the pound against gold was not necessarily the result of any action committed by the Bank, that does not mean that the Bank could not have prevented or reversed the discount by taking remedial or countervailing measures.
The discount against gold might, for example, have occurred, even with no change in the lending practices of the Bank, simply because public confidence in the pound declined after the suspension of convertibility, causing the demand for gold bullion to increase, raising the price of gold in terms of pounds. The Bank could have countered such a self-fulfilling expectation of pound depreciation by raising its lending rate or otherwise restricting credit thereby withdrawing pounds from circulation, preventing or reversing the discount. Because it did not take such countermeasures the Bank did indeed bear some responsibility for the discount against gold.
Although it is not obvious that the Bank ought to have responded in that way to prevent or reverse the discount, the claim of the Bank Directors that, by following the real-bills doctrine, they had done all that they could have done to avoid the rise in prices was both disingenuous and inaccurate. The Bank faced a policy question: whether to tolerate a rise in prices or prevent or reverse it by restricting credit, perhaps causing a downturn in economic activity and increased unemployment. Unwilling either to accept responsibility for their decision or to defend it, the Bank Directors invoked the real-bills doctrine as a pretext to deny responsibility for the discount. An alternative interpretation would be that the Bank Directors’ misunderstanding of the situation they faced was so comprehensive that they were oblivious to the implications of the policy choices that an understanding of the situation would have forced upon them.
The broader lesson of the misguided attempt by the Bank Directors to defend their conduct during the Napoleonic Wars is that the duty of a central bank cannot be merely to maintain its own liquidity; its duty must also encompass the liquidity and stability of the entire system. The liquidity and stability of the entire system depends chiefly on the stability of the general price level. Under a metallic (silver or gold) standard, central banks had very limited ability to control the price level, which was determined primarily in international markets for gold and silver. Thus, the duty of a central bank under a metallic standard could extend no further than to provide liquidity to the banking system during the recurring periods of stress or even crisis that characterized nineteenth-century banking systems.
Only after World War I did it become clear, at least to some economists, that the Federal Reserve had to take responsibility for stabilizing the general price level (not only for itself but for all countries on the restored gold standard), there being no greater threat to the liquidity—indeed, the solvency—of the system than a monetarily induced deflation in which bank assets depreciate faster than liabilities. Unless a central bank control the price level it could not discharge its responsibility to provide liquidity to the banking system. However, the misunderstanding of the real-bills doctrine led to the grave error that, by observing the real-bills doctrine, a central bank was doing all that was necessary and all that was possible to ensure the stability of the price level. However, the Federal Reserve, beguiled by its misunderstanding of the real-bills doctrine and its categorical misapplication to central banking, therefore failed abjectly to discharge its responsibility to control the price level. And the Depression came.
One of my goals when launching this blog in 2011 was to revive interest in the important, but unfortunately neglected and largely forgotten, contributions to monetary and macroeconomic theory of Ralph Hawtrey. Two important books published within the last year have focused attention on Ralph Hawtrey: The Federal Reserve: A New History by Robert Hetzel, and The Capital Order by Clara Elizabeth Mattei.
While Hetzel’s discussion of Hawtrey’s monetary theory of the Great Depression is generally positive, it criticizes him for discounting, unlike Milton Friedman, the efficacy of open-market operations in reviving aggregate demand. But Hetzel’s criticism relies on an incomplete reading of Hawtrey’s discussions of open-market operations. Mattei’s criticism of Hawtrey is very different from Hetzel’s narrow technical criticism. Mattei is clearly deeply hostile to Hawtrey, portraying him as the grey eminence behind the austerity policies of the British Treasury and the Bank of England in the 1920s both before and after Britain restored the prewar gold standard. Mattei holds Hawtrey uniquely responsible for providing the intellectual rationale for the fiscal and monetary policies that ruthlessly tolerated high unemployment to suppress inflation and hold down wages.
I’ll address the inaccuracies in Hetzel’s discussion of Hawtrey and especially in Mattei’s deeply flawed misrepresentations of Hawtrey in future posts. In this post, I provide an overview of Hawtrey’s career drawn from papers I’ve written (two of which were co-authored by my friend Ron Batchelder) about Hawtrey included in my recent book, Studies in the History of Monetary Theory: Controversies and Clarifications (Chapters 10-14)
Ralph George Hawtrey, born in 1879, two years before his friend, fellow Cambridge man and Apostle, John Maynard Keynes, with whom he often disagreed, was in the 1920s and early 1930s almost as well-known as, and perhaps even more influential, at least among economists and policy-makers, than Keynes. Despite their Cambridge educations and careers in economics, as undergraduates, they both concentrated on mathematics[1] and philosophy and were deeply influenced by the Cambridge philosopher, G. E. Moore. Neither formally studied economics under Alfred Marshall.[2]
Perhaps the last autodidact to make significant contributions to economic theory, Hawtrey began his study of economics only when preparing for the civil-service exam at the Treasury. Hawtrey’s Cambridge background, his friendship with Keynes, and the similarities between his own monetary theories and those of Marshall, Keynes and other Cambridge economists contributed to the widespread impression that Hawtrey had ties to the Cambridge school of economics, a connection Hawtrey denied. Hawtrey’s powerful analytical mind, his command of monetary history and deep and wide knowledge of monetary and business institutions, acquired by dint of intense independent study, led to a rapid rise in the Treasury bureaucracy, eventually becoming Director of Economic Studies in 1919, a position he held until he retired from the Treasury in 1945.
Coincidentally, both Hawtrey and Keynes published their first books in 1913, Keynes writing about the reform of the Indian Currency system (Indian Currency and Finance) and Hawtrey propounding his monetary theory of the business cycle (Good and Bad Trade). A more substantive coincidence in their first books is that they both described a gold-exchange standard (resurrecting an idea described almost a century earlier by Ricardo in his Proposals for an Economical and Secure Currency) in which gold coins do not circulate and the central bank holds reserves, not in gold, but in foreign exchange denominated in currencies legally convertible into gold.
The trajectory of Hawtrey’s carrier (like Keynes’s) was sharply upward after publication of his first book. Hawtrey’s reputation was further enhanced by important academic articles about the history of monetary institutions and the gold standard. Those studies were incorporated in Hawtrey’s most important work on monetary economics, Currency and Credit published in 1919, a profound treatise on monetary economics in which his deep theoretical insights were deployed to shed light on important events and developments in the history of monetary institutions. A resounding success, the volume becoming a standard work routinely assigned to students of money and banking for over a decade, establishing Hawtrey as one of the most widely read and frequently cited economists in the 1920s and even the 1930s.
Although Keynes, by virtue of his celebrated book The Economic Consequences of the Peace became one of the most prominent public figures in Britain in the immediate postwar period, Hawtrey’s reputation among economists and policy makers likely overshadowed Keynes’s in the early 1920s. That distinction is exemplified by their roles at the 1922 Genoa Conference on postwar international cooperation and reconstruction.
In his writings about postwar monetary reconstruction, Hawtrey emphasized the necessity for international cooperation to restore international gold standard lest an uncoordinated restoration by individual countries with countries seeking to accumulate gold, thereby causing gold to appreciate and prices in terms of gold to fall. It was Hawtrey’s warnings, echoed independently by the Swedish economist Gustav Cassel, that caused the Treasury to recommend that planning for a coordinated restoration of the gold standard be included in agenda of the Genoa Conference.
While Hawtrey was the intellectual inspiration for including restoration of gold standard on the agenda of the Genoa Conference, Keynes’s role at Genoa was journalistic, serving as a correspondent for the Manchester Guardian. Keynes criticized the plan to reestablish an international gold standard even in the form of a gold-exchange standard that he and Hawtrey had described a decade earlier. Keynes observed that there was then only one nation with an effective gold standard, the United States. Conjecturing that the US, holding 40% of the world’s gold reserves, would likely choose to divest itself of at least part of its gold hoard, causing gold depreciation, Keynes argued that rejoining the gold standard would mean importing inflation from the United States. Keynes therefore recommended that Britain to adopt an independent monetary policy detached from gold to achieve a stable domestic price level.
But after it became clear that the US had no intention of unburdening itself of its huge gold holdings, Keynes reversed his rationale for opposing restoration of the gold standard. Given the depreciation of sterling against the dollar during and after World War I, the goal of restoring the prewar dollar-sterling parity of $4.86/pound would require Britain to endure even more deflation than it had already suffered following the sharp US deflation of 1920-21.
When Winston Churchill, appointed Chancelor of the Exchequer in the new Conservative Government, announced in November 1924 that he would restore the gold standard at the prewar parity by April 1925, the pound appreciated against the dollar. But the market exchange rate with the dollar remained 10% below the prewar parity. Keynes began arguing against restoring the prewar parity because a further 10% deflation would impose an unacceptable hardship on an economy that had not recovered from the effects of the recession and high unemployment caused by earlier deflation.
After personally consulting Keynes in person about his argument against restoring the prewar parity, Churchill also invited Hawtrey to hear his argument in favor of restoring the prewar parity. Hawtrey believed that doing so would bolster London’s position as the preeminent international financial center. But he also urged that, to avoid the dire consequences that Keynes warned would follow restoration of the prewar parity, the Bank of England reduce Bank Rate to promote economic expansion and employment. Given the unique position of London as the center of international finance, Hawtrey was confident that the Bank of England could ease its monetary policy and that the Federal Reserve and other central banks would ease their policies as well, thereby allowing the gold standard to be restored without significant deflation.
Supported by his Treasury advisers including Hawtrey, Churchill restored the gold standard at the prewar dollar parity in April 1925, causing Keynes to publish his brutal critique of that decision in his pamphlet The Economic Consequences of Mr. Churchill. While the consequences were perhaps not as dire as Keynes had predicted, they were less favorable than Hawtrey had hoped, the Bank of England refusing to reduce Bank Rate below 5% as Hawtrey had urged. At any rate, after a brief downturn in the latter part of 1925, the British economy did expand moderately from 1926 through early 1929 with unemployment declining slightly before Britain, along with the rest of the world, plunged into the Great Depression in the second half of 1929.
Keynes and Hawtrey again came into indirect opposition in the 1929 general election campaign, when Lloyd George, leader of the Liberal Party, proposed a program of public works to increase employment. In rejecting Lloyd George’s proposal, Churchill cited the “traditional Treasury view” that public spending simply displaced an equal amount of private spending, merely shifting spending from the private to the public sector without increasing total output and employment.
The source of “the traditional Treasury” view” was Hawtrey, himself, who had made the argument at length in a 1925 article in the Economic Journal which he had previously made in less detail in Good and Bad Trade. Replying to Churchill, Keynes and Hubert Henderson co-authored a pamphlet Can Lloyd George Do It supporting Lloyd George’s proposal and criticizing the Treasury View.
Keynes and Hawtrey confronted each other in person when Hawtrey testified before the Macmillan Committee investigating the causes of high unemployment. As a member of the Committee, Keynes questioned Hawtrey about his argument that the Bank of England could have countered rising unemployment by reducing Bank Rate, seemingly exposing an inconsistency in Hawtrey’s responses to his questions. But, when considered in light of Hawtrey’s assumption that a reduction in Bank Rate by the Bank of England would have led to Federal Reserve and other central banks to reduce their interest rates rather than absorb further inflows of gold, the inconsistency is resolved (see this post for further explanation).
Although Hawtrey had warned of the dreadful consequences of restoring the gold standard without coordination among central bank to avoid rapid accumulation of gold reserves, his warnings were disregarded when France returned to the gold standard in 1927 and began rapidly increasing its gold reserves in 1928. Hawtrey’s association with the Treasury view fostered the misimpression that, despite his unheeded advocacy of reducing Bank Rate to reduce unemployment, Hawtrey was oblivious to, or unconcerned by, the problem of unemployment. While Keynes often tried out new ideas, as he did with his neo-Wicksellian theory of the business cycle in his Treatise on Money only to abandon it in response to criticism and the changing economic environment of the Great Depression before writing his General Theoryof Interest, Income and Money, Hawtrey stuck to the same basic theory developed in his first two books.
While his output of new publications in the 1930s did not flag, Hawtrey’s reputation among economists and his influence in the Treasury gradually declined, especially after publication of Keynes’s General Theory as the attention of economists was increasingly occupied by an effort to comprehend and assimilate it into the received body of economic theory. By the time he retired from the Treasury in 1945 to become Professor of International Economics at the Royal Institute for International Affairs, Hawtrey was no longer at the cutting edge of the economics profession, and his work gradually fell from the view of younger economists.
Nevertheless, for the next two decades as he advanced to old age, Hawtrey continued to publish important works, mostly, but not exclusively concerning the conduct of British monetary policy, especially his lonely criticism of Britain’s 1947 devaluation of the pound. Elaborating on arguments advanced in his early writings, Hawtrey anticipated much of what would become known as the monetary approach to the balance of payments.
Given his monetary explanation of the Great Depression, it might have been expected that Monetarists, especially Milton Friedman, who, in the early 1950s, began his effort to develop a monetary theory of the Great Depression as an alternative to the Keynesian theory of a sudden decline in animal spirits that caused a stock-market crash and a drop in investment spending from which the private economy could not recover on its own, would have found Hawtrey’s explanation of the causes of the Great Depression to be worth their attention. However, one would search for Hawtrey’s name almost in vain in Friedman’s writings in general, and in his writings on the Great Depression, in particular. Certainly there was no recognition in the Monetarist literature on the Great Depression that a monetary theory of the Great Depression had actually been advanced by Hawtrey as the Great Depression was unfolding or that Hawtrey had warned in advance of the danger of the catastrophic deflation that would result from an uncoordinated restoration of the gold standard.
Years after Friedman’s magnum opus The Monetary History of the US was published, various researchers, including Peter Temin, Barry Eichengreen, Ben Bernanke, Kenneth Mouré, Clark Johnson, Scott Sumner, and Ronald Batchelder and I, recognized the critical importance of the newly restored gold standard in causing the Great Depression. While most of the later authors cited Hawtrey’s writings, the full extent of Hawtrey’s contributions that fully anticipated all the major conclusions of the later research remains generally unrecognized in most of the recent literature on the Great Depression, while Friedman’s very flawed account of the Great Depression continues to be regarded by most economists and financial historians as authoritative if not definitive.
In a future post, I’ll discuss Hetzel’s account of Hawtrey’s explanation of the Great Depression. Unlike earlier Monetarists who ignored Hawtrey’s explanation entirely, Hetzel does credit Hawtrey with having provided a coherent explanation of the causes of the Great Depression, without acknowledging the many respects in which Hawtrey’s explanation is more complete and more persuasive than Friedman’s. He also argues that Friedman provided a better account of the recovery than Hawtrey, because Friedman, unlike Hawtrey, recognized the effectiveness of open-market operations which Hawtrey maintained would be ineffective in initiating a recovery in situations of what Hawtrey called credit deadlock.
In another post, I’ll discuss the highly critical, and I believe tendentious, treatment by Clara Elizabeth Mattei, of Hawtrey’s supposed role in devising and rationalizing the austerity policies of the British Treasury in the 1920s up to and including the Great Depression.
[1] While Keynes was an accomplished mathematician who wrote an important philosophical and mathematical work A Treatise on Probability praised extravagantly by Bertrand Russell, Hawtrey’s mathematical skills were sufficiently formidable to have drawn the attention of Russell who included a footnote in his Principia Mathematica replying to a letter from Hawtrey.
[2] Keynes, however, the son of John Neville Keynes, a Cambridge philosopher and economist, had a personal connection to Marshall apart from his formal studies at Cambridge. Rather than pursue graduate studies, Hawtrey chose a career in the civil service, first at the Admiralty and soon thereafter at the Treasury.
UPDATE: My concluding paragraph was inadverently deleted from my post, so even if you’ve already read the post, you may want to go back and read my concluding paragraph.
Last December, Nathan Tankus wrote an essay for his substack site defending Arthur Burns and his record as Fed Chairman in the 1970s when inflation rose to double digits, setting the stage for Volcker’s shock therapy in 1981-82. Tankus believes that Burns has been blamed unfairly for the supposedly dreadful performance of the economy in the 1970s, a decade that probably ranks second for dreadfulness, after the 1930s, in the economic history of the 20th century. Nathan is not the first commentator or blogger I’ve seen over the past 10 years or so to offer a revisionist, favorable, take on Burns’s tenure at the Fed. Here are links to my earlier posts on Burns revisionism (link, link, link)
Nathan properly criticizes the treatment of the 1970s in journalistic mentions to that fraught decade. The decade endured a lot of unpleasantness along with the chronically high inflation that remains its most memorable feature, but it was also a decade of considerable economic growth, and, despite three recessions and rising unemployment, a huge increase in total US employment.
Nathan believes that Burns has been denigrated unfairly as a weak Fed Chairman who either ignored the inflationary forces, or succumbed, despite his conservative, anti-inflationary, political inclinations, to Nixon’s entreaties and pressure tactics, and deployed monetary policy to assist Nixon’s 1972 re-election campaign. Although the latter charge has at least some validity – it’s no accident that the literature on political business cycles, especially a seminal 1975 paper on that topic by William Nordhaus, a future Nobel laureate, was inspired by the Burns-Nixon episode – it’s not the whole story.
But, what is more important than Burns being cajoled or coerced by Nixon to speed the recovery from the 1969-70 recession, is that Burns was the victim of his own conceptual error in supposing that, if the incomes policy that he favored were adtoped, monetary expansion by the Fed wouldn’t lead to the inflationary consequences that they ultimately did have. Burns’s conceptual failure — whether willful or thoughtless — was to overlook the relationship between aggregate income and inflation. Although his confusion about that critical relationship was then widely, though not universally, held, his failure seems obvious, almost banal. But there were then only a few able to both identify and explain the failure and draw the appropriate policy implications. (In an earlier post about Burns, I’ve discussed Ralph Hawtrey’s final book published in 1966, but likely never noticed by Burns, in which the confusions were clearly dispelled and the appropriate policy implications clearly delineated.)
Nathan attributes the deterioration of Burns’s reputation to the influence of Milton Friedman, who wrote his doctoral dissertation under Burns at Columbia. Friedman, to be sure, was sharply critical of Burns’s performance at the Fed, but the acerbity of Friedman’s criticism also reflects his outrage that Burns had betrayed conservative, or “free-market”, principles by helping to persuade Nixon to adopt wage-and-price controls in 1971. Though I share Friedman’s disapproval of Burns’s role in the adoption of wage-and-price controls, Burns’s monetary-policy can be assessed independently of how one views the merits of the wage-and-price controls sought by Burns.
Here’s how Nathan describes Burns:
The actual Burns was – in his time – a well respected Monetary Policy “Hawk” who believed deeply in restrictive austerity. This was nearly universally acknowledged during his tenure, and then for a few years after. A New York Times article from 1978 about Burns’s successor, George Miller illustrates this well. Entitled “Miller Fights Inflation In Arthur Burns’s Style”, the article argues that Miller tightened monetary policy far more aggressively than the Carter administration expected and spoke in conservative, inflation focused and austere terms. In other words, he was a clone of Arthur Burns.
The reason this has been forgotten is the total victory of one influential dissenter: Milton Friedman. Milton Friedman, in real time, pilloried his former mentor as a money supply expanding inflationist. That view deserves its own piece sometime (spoiler: it’s mostly wrong.)
Given Friedman’s dictum — “inflation is always and everywhere a monetary phenomenon” – it’s no surprise that Friedman blamed the Federal Reserve and Burns for inflation. While confidently asserting on the one hand that changes in the quantity of money cause corresponding changes in prices, Friedman, on the other hand, invoked unexplained long and variable lags between changes in the quantity of money and changes in prices to parry evidence that the supposed correlations were less than clear-cut. So, Friedman’s narrow focus on the quantity of money rather than on total spending – increaes in the quantity of money being as much an effect as a cause of increased nominal spending and income — actually undercut his critique of Fed policy. In what follows I will therefore not discuss the quantity of money, which was, in Friedman’s mind, the key variable that had to be controlled to reduce or stop inflation. Instead, I focus on the behavior of total nominal spending (aka aggregate demand) and total nominal income, which is what monetary policy (perhaps in conjunction with fiscal policy) has some useful capacity to control.
Upon becoming Fed Chairman early in 1970, Burns continued the monetary tightening initiated by his predecessor in 1969 when inflation had risen to 6%. Although the recession caused by that tightening had started only two months before Burns succeeded Martin, inflation hardly declined, notwithstanding a steady rise in unemployment from the 3.4% rate inherited by Nixon in January 1969, at the start of his Presidency, to 4.2% when Burns became Chairman, and to 6.1% at the end of 1970.
The minimal impact of recession on inflation was troubling to Burns, reinforcing his doubts about the efficacy of conventional monetary and fiscal policy tools in an economy that seemed no longer to operate as supposed by textbook theory. It wasn’t long before Burn, in Congressional testimony (5/18/1970) voiced doubts about the efficacy of monetary policy in restraining inflation.
Another deficiency in the formulation of stabilization policies in the United States has been our tendency to rely too heavily on monetary restriction as a device to curb inflation…. severely restrictive monetary policies distort the structure of production. General monetary controls… have highly uneven effects on different sectors of the economy. On the one hand, monetary restraint has relatively slight impact on consumer spending or on the investments of large businesses. On the other hand, the homebuilding industry, State and local construction, real estate firms, and other small businesses are likely to be seriously handicapped in their operations. When restrictive monetary policies are pursued vigorously over a prolonged period, these sectors may be so adversely affected that the consequences become socially and economically intolerable.
We are in the transitional period of cost-push inflation, and we therefore need to adjust our policies to the special character of the inflationary pressures that we are now experiencing. An effort to offset, through monetary and fiscal restraints, all of the upward push that rising costs are now exerting on prices would be most unwise. Such an effort would restrict aggregate demand so severely as to increase greatly the risks of a very serious business recession. . . . There may be a useful… role for an incomes policy to play in shortening the period between suppression of excess demand and restoration of reasonable price stability.
Quoted by R. Hetzel in “Arthur Burns and Inflation” Federal Reserve Bank of Richmond Economic Quarterly, Winter 1998
The cost-push view of inflation that Burns articulated was not a new one for Burns. He had discussed it in a 1967 lecture at a seminar organized by the American Enterprise Institute concerning the wage-price guideposts, which had been invoked during the Eisenhower administration when he was CEA Chairman, and were continued in the Kennedy-Johnson administrations, to discourage labor and business from “excessive” increases in wages and prices.
The seminar consisted of two lectures, one by Burns (presumably offering a “conservative” or Republican view) and another by Paul Samuelson (offering a “liberal” or Democratic view), followed by the responses each to the other, and finally by questions from an audience of economists drawn from Washington-area universities, think-tanks and government agencies, and the responses of Burns and Samuelson. Transcripts of the lectures and the follow-up discusions were included in a volume published by AEI.
Inflation had become a contentious political issue in 1967, Republicans blaming the Johnson Administration for the highest inflation since the early 1950s. Though Burns, while voicing mild criticism of how the guideposts were administered and skepticism about their overall effect on inflation, neither rejected them on principle nor dismissed them as ineffective.
So, Burns did not arrive at the Fed as an ideological opponent of government intervention in the decisions of business and organized labor. Had Milton Friedman participated in the AEI seminar, he would have voiced implacable opposition to the guideposts as ineffective in practice and an arbitrary — extra-legal and therefore especially obnoxious — exercise of government power over the private sector. Burns’s conservatism, unlike Friedman’s, was the conventional Republican pro-business attitude, and, as Nathan himself notes, business wasn’t at all averse to government assistance in resisting union wage demands.
That doesn’t mean that Burns’s views hadn’t changed since 1967 when he voiced tepid support for guideposts as benchmarks for business and labor in setting prices and negotiating labor contracts. But the failure of monetary tightening and a deepening recession to cause more than a minimal slowdown in inflation seems to have shattered Burns’s shaky confidence that monetary policy could control inflation.
Unlike the preceding recessions in which increased (but still low) inflation quickly led to monetary tightening, the 1969-70 recession began only after inflation had risen steadily for five years from less than 2% in 1965 to 6% in 1969. It’s actually not surprising — it, at least, shouldn’t have been — that, after rising steadily for five years and becoming ingrained in public expectations, inflation would become less responsive to monetary tightening and recession than it had been before becoming ingrained in expectations. Nevertheless, the failure of a recession induced by monetary tightening to curtail inflation seems to have been considered by Burns proof that inflation is not a purely monetary phenomenon.
The further lesson drawn by Burns from the minimal decline in inflation after a year of monetary tightening followed by a recession and rising unemployment was that persistent inflation reflects the power of big business and big labor to keep raising prices and wages regardless of market conditions. The latter lesson became the basis of his approach to the inflation problem. Inflation control had to reckon with the new reality that, even if restrictive monetary and fiscal policies were adopted, it was big business and big labor that controlled pricing and inflation.
While the rationale that Burns offered for an incomes policy differed little from the rationale for the wage-price guideposts to which Burns had earlier paid lip-service, in articulating the old rationale, perhaps to provide the appearance of novelty, Burns found it useful to package the rationale in a new terminology — the vague British catchphrase “incomes policy” covering both informal wage-price guideposts and mandatory wage-price controls. The phrase helped him justify shifting monetary policy from restraint to stimulus, even though inflation was still unacceptably high, by asserting that responsibility for controlling inflation was merely being transferred, not abandoned, to another government entity with the legal power and authority to exercise that control.
It’s also noteworthy that both Burns’s diagnosis of inflation and the treatment that he recommended were remarkably similar to the diagnosis and treatment advanced in a 1967 best-selling book, The New Industrial State, by the famed Harvard economist and former adviser to President Kennedy, J. K. Galbraith.
Despite their very different political views and affiliations, Burns and Galbraith, both influenced by the Institutionalist School of economics, were skeptical of the standard neoclassical textbook paradigm. Galbraith argued that big corporations make their plans based on the prices and wages that they can impose on their smaller suppliers and smaller customers (especially, in Galbraith’s view, through the skillful deployment of modern advertising techniques) while negotiating pricing terms with labor unions and other large suppliers and with their large customers. (For more on Galbraith see this post.)
Though more sympathetic to big business and less sympathetic to big labor than Galbraith, Burns, by 1970, seems to have fully internalized, whether deliberately or inadvertently, the Galbrathian view of inflation.
Aside from his likely sincere belief that conventional anti-inflationary monetary and fiscal policy were no longer effective in an economy dominated by big business and big labor, Burns had other more political motivations for shifting his policy preferences toward direct controls over wages and prices. A full account of his thinking would require closer attention to the documentary record than I have undertaken, but, Burns was undoubtedly under pressure from Nixon to avoid a recession in the 1972 election year like the one precipitated by the Fed in 1960 when the Fed moved to suppress a minor uptick in inflation following its possibly excessive monetary stimulus after the 1957-58 recession. Burns had warned Nixon in 1960 that a looming recession might hurt his chances in the upcoming election, and Nixon thereafter blamed his 1960 loss on the Fed and on the failure of the Eisenhower adminisration to increase spending to promote recovery. Moreover, the disastrous (for Republicans) losses in the 1958 midterm elections were widely attributed to the 1957-58 recession. Substantial GOP losses in the 1970 midterms, plainly attributable to the 1970 recession, further increased Nixon’s anxiety and his pressure on Burns to hasten a recovery through monetary expansion to ensure Nixon’s reelection.
But it’s worth taking note of a subtle difference between the rationale for wage-price guideposts and the rationale for an incomes policy. While wage-price guideposts were aimed solely at individual decisions about wages and prices, the idea of an incomes policy had a macroeconomic aspect: reconciling the income demands of labor and business in a way that ensured consistency between the flow of aggregate income and low inflation. According to Burns, reconciling those diverse and conflicting income demands with low inflation required an incomes policy to prevent unrestrained individual demands for increased wages and prices from expanding the flow of income so much that inflation would be the necessary result.
What Burns and most other advocates of incomes policies overlooked is that incomes are generated from the spending decisions of households, business firms and the government. Those spending decisions are influenced by the monetary- and fiscal-policy choices of the monetary and fiscal authorities. Any combination of monetary- and fiscal-policy choices entails corresponding flows of total spending and total income. For any inflation target, there is a set of monetary- and fiscal-policy combinations that entails flows of total spending and total income consistent with that target.
Burns’s fallacy (and that of most incomes-policy supporters) was to disregard the relationship between total spending and monetary- and fiscal-policy choices. The limits on wage increases imposed by an incomes policy can be maintained only if a monetary- and fiscal-policy combination consistent with those limits is chosen. Burns’s fallacy is commonly known as the fallacy of composition: the idea that what is true for one individual in a group must be true for the group as a whole. For example, one spectator watching a ball game can get a better view of the game by standing up, but if all spectators stand up together, none of them gets a better view.
Wage increases for one worker or for workers in one firm can be limited to the percentage specified by the incomes policy, but the wage increases for all workers can’t be limited to the percentage specified by the incomes policy unless the chosen monetary- and fiscal-policy combination is consistent with that percentage.
If aggregate nominal spending and income exceed the nominal income consistent with the inflation target, only two outcomes are possible. The first, and more likely, outcome is that the demand for labor associated with the actual increase in aggregate demand will overwhelm the prescribed limit on wage increases. If it’s in the interest of workers to receive wage increases exceeding the permitted increase — and it surely is — and if it’s also in the interest of employers trying to increase output because demand for their output increases by more than expected, making it profitable to hire additional workers at increased wages, it’s hard to imagine that wages wouldn’t increase by more than the incomes policy allows. Indeed, since price increases are typically allowed only if costs increase, there’s an added incentive for firms to agree to wage increases to make price increases allowable.
Second, even if the limits on wage increases were not exceeded, those limits imply an income transfer from workers to employers. The implicit income redistribution might involve some reduction in total spending and in aggregate demand, but, ultimately, as long as the total spending and total income associated with the chosen monetary- and fiscal-policy combination exceeds the total income consistent with the inflation target, excess demands for goods will either cause domestic prices to rise or induce increased imports at increased prices, thereby depreciating the domestic currency and raising the prices of imported final goods and raw materials. Those increased prices and costs will be a further source of inflationary pressure on prices and on wages, thereby increasing inflation above the target or forcing the chosen monetary- and fiscal-policy combination to be tightened to prevent further currency depreciation.
To recapitulate, Burns actually had the glimmering of an insight into the problem of reducing inflation in an economy in which most economic agents make plans and decisions based on their inflationary expectations. When people make plans and commitments in expectation of persistent future inflation, reducing, much less stopping, inflation is hard, because doing so must disappoint their expectations, rendering the plans and commitments based on those expectations costly, or even impossible, to fulfill. The promise of an incomes policy is that, by gradually reducing inflation and facilitating the implementation of the fiscal and monetary policies necessary to reduce inflation, it can reduce expectations of inflation, thereby reducing the cost of reducing inflation by monetary and fiscal restraint.
But instead of understanding that an incomes policy aimed at reducing inflation by limiting the increases in wages and prices to percentages consistent with reduced inflation could succeed only if monetary and fiscal policies were also amed at slowing the growth of total spending and total income to rates consistent with the inflation target, Burns conducted a monetary policy with little attention to its consistency with explicit or implicit inflation targets. The failure to reduce the growth of aggregate spending and income rendered the incomes policy unfeasible, thereby ensuring the incomes policy aiming to reduce inflation would fail. The failure to grasp the impossibility of controlling wage-and-pricing decisions at the micro level without controlling aggregate spending and income at the macro level was the fatal conceptual mistake that guaranteed Burns’s failure as Fed Chairman. Perhaps Burns’s failure was tragic, but failure it was.
Let’s now look at the results of Burns’s monetary policies. The chart below shows the annual rates of change in nominal GDP and real GDP from Q1-1968 to Q1-1980
To give Burns his due, the freeze and the cost-of-living council that replaced it 90 days afterwards was a splendid political success, igniting an immediate stock-market boom and increasing Nixon’s popularity with both Democrats and Republicans notwithstanding Nixon’s repudiation of his repeated pledges never to impose wage-and-price controls. Burns continued — though erratically — the monetary easing that he began at the end of 1970, providing sufficient stimulus to reduce unemployment, which had barely budged from the peak rate of 6.1% in December 1970 to 6.0% in September 1971. While the decline in the unemployment rate was modest, to 5.6% in October 1972, the last official report before the election, total US employment between June 1970 (when US employment was at its cyclical trough) and October 1972 increased by 5%, reflecting both cyclical recovery and the beginning of an influx of babyboomers and women into the labor force.
The monetary stimulus provided by the Fed between the end of the recession in November 1970 and October 1972 can be inferred from the increase in total spending and income (as measured by nominal GDP) from Q1-1971 and Q3-1972. In that 7-quarter period, total spending and income increased by 18.6% (corresponding to an annual rate of 10.6%). Because the economy in Q4-1970 was still in a recession, nominal spending and income could increase at a faster rate during the recovery while inflation was declining than would have been consistent with the inflation target if maintained permanently.
But as the expansion continued, with employment and output expanding rapidly, the monetary stimulus should have been gradually withdrawn to slow the growth of total spending and income to a rate consistent with a low inflation target. But rather than taper off monetary stimulus, the Fed actually allowed total spending and income growth to accelerate in the next three quarters (Q4-1972 through Q2-1973) to an annual rate of 12.7%.
Inflation, which at first had shown only minimal signs of increasing as output and employment expanded rapidly before the 1972 election, not surprisingly began to accelerate rapidly in the first half of 1973. (The chart below provides three broadly consistent measures of inflation (Consumer Price Index, Personal Consumption Expenditures, and GDP implicit price deflator at quarterly intervals). The chart shows that all three measures show inflation rising rapidly in the first hals of 1973, with inflation in Q2-1973 in a range between 6.3% and 8.6%.
Burns rejected criticisms that the Fed was responsible for resurgent inflation, citing a variety of special factors like rising commodity prices as the cause of rising inflation. But, having allowed the growth of total spending and income to accelerate from Q4-1972 and Q2-1973, in violation of the rationale for the incomes policy that he had recommended, Burns had no credible defense of the Fed’s monetary policy.
With inflation approaching double digit levels – the highest in over 20 years – Burns and the Fed had already begun to raise interest rates in the first half of 1973, but not until the third quarter did rates rise enough to slow the growth of total spending and income. A belated tightening was, of course, in order, but, as if to compensate for its tardiness, the Fed, as it has so often been wont to do, tightened too aggressively, causing the growth of total spending to decline from 11% in Q2 1973 to less than 5% in Q3 1973, a slowdown that caused real GDP to fall, and the unemployment rate, having just reached its lowest point (4.6%) since April 1970, a rate not matched again for two decades, to start rising.
Perhaps surprised by the depth of the third-quarter slowdown, the Fed eased policy somewhat in the fourth quarter until war broke out between Egypt, Syria and Israel, soon followed by a cutback in overall oil production by OPEC and a selective boycott by Arab oil producers of countries, like the US, considered supportive of Israel. With oil prices quadrupling over the next few months, the cutback in oil production triggered a classic inflationary supply shock.
It’s now widely, though not universally, understood that the optimal policy response to a negative supply shock is not to tighten monetary policy, but to allow the price level to increase permanently and inflation to increase transitorily, with no attempt to reverse th price-level and inflation effects. But, given the Fed’s failure to prevent inflation from accelerating in the first half of 1973, the knee-jerk reaction of Burns and the Fed was to tighten monetary policy again after the brief relaxation in Q4-1973, as if previous mistakes could be rectified by another in the opposite direction.
The result was, by some measures, the deepest recession since 1937-38 with unemployment rising rapidly to 9% by May 1975. Because of the negative supply shock, most measures of inflation, despite monetary tightening, were above 10% for almost all of 1974. While the reduction in nominal GDP growth during the recession was only to 8%, which, under normal conditions, would have been excessive, the appropriate target for NGDP growth, given the severity of the supply shock that was causing both labor and capital to be idled, would, at least initially, have been closer to the pre-recession rate of 12.7% than to 8%. The monetary response to a supply shock should take into account that, at least during the contraction and even in the early stages of a recovery, monetary expansion, by encouraging the reemployment of resources, thereby moderating the decline in output, can actually be disinflationary.
I pause here to observe that inflation need not increase just because unemployment is falling. That is an inference often mistakenly drawn from the Phillips Curve relationship between unemployment and inflation. It is a naive and vulgar misunderstanding of the Phillips Curve to assume that dcelining unemployment is always and everywhere inflationary. The kernel of truth in that inference is that monetary expansion tends to be inflationary when the economy operates at close to full employment without sufficient slack to allow output to increase in proportion to an increase in aggregate spending. However, when the economy is operating with slack and is far from full employment, the inference is invalid and counter-productive.
Burns eventually did loosen monetary policy to promote recovery in the second half of 1975, output expanding rapidly even as inflation declined to the mid-single digits while unemployment fell from 9% in May 1975 to 7.7% in October 1976. But, just as it did after the 1972 Presidential election, growth of NGDP actually increased after the 1976 Presidential election.
In the seven quarters from Q1-1975 through Q3-1976, nominal GDP grew at an average annual rate of 10.2%, with inflation fallng from a 7.7% to 9.4% range in Q1-1975 to a 5.3% to 6.5% range in Q3-1976; in the four quarters from Q4-1976 through Q3-1977, nominal GDP grew at an average rate of 10.9%, with inflation remaining roughly unchanged (in the 5% to 6.2% range). Burns may have been trying to accommodate the desires of the Carter Administration to promote a rapid reduction in unemployment as Carter had promised as a Presidential candidate. Unemployment in March 1977 stood at 7.4% no less than it was in May 1976. While the unemployment rate was concerning, unemployment rates in the 1970s reflected the influx of baby boomers and women lacking work experience into work force, which tended to increase measured unemployment despite rapid job growth. Between May 1976 and March 1977, for example, an average of over 200,000 new jobs a month were filled despite an unchanged unemployment rate.
As it became evident, towards the end of 1977 that Burns would not be reappointed Chairman, and someone else more amentable to providing further monetary stimulus would replace him, the dollar started falling in foreign-exchange markets, almost 7% between September 1977 and March 1978, a depreciation that provoked a countervailing monetary tightening and an increase in interest rates by the Fed. The depreciation and the tightening were reflected in reduced NGDP growth and increased inflation in Q4 1977 and Q1 1978 just as Burns was being replaced by his successor G. William Miller in March 1978.
So, a retrospective on Burns’s record as Fed Chairman provides no support for a revisionist rehabilitation of that record. Not only did Burns lack a coherent theoretical understanding of the effects of monetary policy on macroeconomic performance, which, to be fair, didn’t set him apart from his predecessors or successors, but he allowed himself to be beguiled by the idea of an incomes policy as an alternative to monetary policy as a way to control inflation. Had he properly understood the rationale of an incomes policy, he would have realized that it could serve a useful function only insofar as it supplemented, not replaced, a monetary policy aiming to reduce the growth of aggregate demand to a rate consistent with reducing inflation. Instead, Burns viewed the incomes policy as a means to eliminate the upward pressure of wage increases on costs, increases that, for the most part, merely compensated workers for real-wage reductions resulting from previous unanticipated inflation. But the cause of the cost-push phenomenon that was so concerning to Burns is aggregate-demand growth, which either raises prices or encourages output increases that make it profitable for businesses to incur those increased costs. Burns’s failure to grasp these causal relationships led him to a series of incoherent policy decisions that gravely damaged the US economy.
Jason Furman has had an admirable career as an economist and policy adviser. He was on the staff of the Council of Economic Advisors in the Clinton administrations, was Assistant Director of the National Economic Policy under Larry Summers in Obama’s first term served as Chairman of the CEA in his second. I am friendly with a really smart economist who worked under Furman for a couple of years at the CEA, and he spoke glowingly about that experience in general and about Furman in particular, both as an economist and as a person. So I’m not anxious to write a critical blogpost about Furman. But a blogger’s gotta do what a blogger’s gotta do.
Following the lead of his former boss Larry Summers, Furman has, for over a year, been an outspoken anti-inflation hawk, calling for aggressive tightening by the Fed to prevent an inflationary wage-price spiral from returning us to the bad old days of the 1970s and its ugly aftermath — the 1981-82 Volcker recession. So, after the January core inflation reports showed an uptick in core inflation in the second half of 2022, Furman responded with an overwrought op-ed (“To Fight Inflation, Fed Tightening Should Go Faster and Further”) in the Wall Street Journal.
The Federal Reserve has said repeatedly that it responds to data and doesn’t set interest rates on autopilot. The data have changed dramatically. The Fed should prove it means what it says by shifting from a 25-basis-point increase at its next meeting to a 50-point increase. It should also shift expectations toward a terminal rate of around 6%.
The Fed should never react too much to any single data point, but when the annualized three-month core inflation rate jumps from 2.9% to 4.7%, the central bank must take notice. When that happens after strong jobs data and faster wage growth, the Fed should plan on action. The expectation that inflation would melt away on its own was always unjustified, but the latest economic data have been especially unkind to team transitory.
Let me first observe that Furman seems to overstate the size of the January increase in core inflation. Core inflation, which excludes volatile food and energy prices from the two broader inflation indexes: the personal consumption expenditures index (PCEI) computed by the Bureau of Economic Analysis of the Commerce Department and the Consumer Price Index (CPI) computed by the Bureau of Labor Statistics of the Labor Department. The two charts below show the 3-month and the 6-month moving averages of the core PCEI and the core CPI. Neither of the 3-month moving averages show a January increase as large as that asserted by Furman.
Yet, Furman is correct that the January increase in core inflation was significant, and also correct to observe that the Fed shouldn’t overreact to a single data point. Unfortunately, he immediately reversed himself by demanding that the Fed respond to the January increase by quickly and significantly tightening policy, because core inflation, notwithstanding the assurances of “team transitory”, has not subsided much on its own.
I can’t speak on behalf of team transitory, but, as far as I know, no one ever suggested that inflation would fall back to the Fed’s 2% target on its own. Everyone acknowledged that increased inflation last year was, at least partly, but not entirely, caused by macroeconomic policies that, during the pandemic and its aftermath, first supported, and then increased, aggregate demand.
But, as I’ve argued in many posts in the past year and a half (here, here, here, here, here, here, here, and here), increasing aggregate demand to avoid a cumulative collapse in output and income was well-advised under unprecedented Covid conditions. Because much of the income supplements provided in 2020-21 were held in cash, or used to repay debts, owing to the diminished availability of spending outlets during the pandemic, rather than spent, increased aggregate demand led not to an immediate, but a delayed, increase in inflation once the economy gradually recovered from the pandemic. Without the macroeconomic stimulus of 2020-21 that became a source of inflationary pressure in late 2021 and 2022, the downturn in 2020 would have been even deeper and lasted longer.
But aside from the underlying macroeconomic forces causing inflation to start rising in 2021, a variety of supply-chain slowdowns and interruptions appeared, just as a Russian invasion of Ukraine was becoming increasing likely, driving up oil and other energy prices well before the actual invasion on February 24, 2022. The transitory component of inflation corresponds to both the delayed spending of cash accumulated from income supplements and other spending undertaken in the pandemic, and to the supply-side problems caused by, or related to both the pandemic and Putin’s war. By the middle of 2022, both of these transitory causes of inflation were subsiding.
That leaves us with a core rate of inflation hovering in the 4-5% range, a somewhat higher rate than I would like, or recommend, as a policy target. Does that mean that further tightening to reduce overall inflation to the 2% target is required? I agree with Furman and others who think it is required, but I disagree that the tightening should be either drastic or immediate, and I find Furman’s rationale for rapid and substantial further tightening deeply misguided.
What makes the current inflation particularly troubling is that all the hoped-for saviors have come and gone without reducing underlying inflation very much. Inflation was supposed to go away after base effects receded, when the economy got over the Delta and Omicron surges, when the ports were unclogged, when timber prices fell, when the fiscal stimulus wore off, when microchips were available, when energy prices came back down again after the Russian invasion. All of that has happened, and yet the underlying inflation rate remains above 4.5% on just about every time horizon and every measure.
What makes Furman’s inflation anxiety particularly annoying is that, while he and others had been warning that, unless the Fed sharply tightened, inflation would accelerate — possibly to double-digit levels — he continues to hyperventilate about runaway inflation, even as headline inflation over the past year has dropped substantially, and core inflation has also fallen, albeit by much less than headline inflation. Having learned nothing from his earlier exaggerated warnings about inflation, Furman is now using a one-month uptick in inflation as a pretext for continued inflation alarmism and tight-money advocacy.
The Fed’s tightening over the past year prevented core inflation from accelerating even as the transitory factors that had raised inflation to the highest levels in 50 years gradually dissipated, causing the sharp decline in the volatile non-core items in the CPI and PCE indexes. The argument between team transitory and team non-transitory was never an all or nothing dispute, but a matter of emphasis.
Many of those opposed to rapid and severe tightening understood that responding too aggressively to temporarily high inflation carries risks of its own, potentially plunging the economy into a recession because of an exaggerated estimate of the inflationary threat, an underrated risk that is one of the 1970s lessons that many, including Furman and Summers, seem to overlook, but a risk of which the events of the past two weeks have provided an unwelcome and frightening reminder.
The modest decline in core inflation over the past year was accompanied by a gradual decline in the rate of NGDP growth since the first quarter of 2022 from over 11% to about 7%. For inflation to decline further toward the 2% target, a further modest — and ideally gradual — decline in NGDP growth to about 5% will be necessary.
Whether the decline in NGDP growth is possible without further monetary tightening is unclear, but it’s unlikely that the effects of monetary tightening over the past year have yet been fully absorbed by the economy, so it seems reasonable to postpone any decision about monetary tightening until at least the preliminary Q1 GDP report is released in about six weeks. And given the heightened risk to the banking and financial system, any increase in rates would be foolhardy.
If total domestic spending is increasing at a rate faster than 7%, further increases in interest rates might be warranted, but the current inversion of the yield curve suggests that an increase in short-term rates is presumptively inadvisable (see my posts on yield-curve inversion here and here). If long-term rates are below short-term rates, notwithstanding the incremental risk associated with holding securities of longer duration, the relatively low yield of longer-term securities suggests either that the liquidity premium on money is abnormally high (a symptom of financial distress), or that there is an expectation of sharply declining yields in the future. In the former case, a lack of liquidity and increasing default risk drive up short-term rates; in the latter, the longer-term outlook suggests that the inflation rate, or the profit rate, or both, will decline. So the watchword about policy changes should be: caution.
After that warmup, Furman, in diagnosing “underlying inflation, goes from being annoying to misguided.
Fundamentally, much of the economy’s underlying inflation had nothing to do with base effects or microchips or timber prices.
Correct! But let’s say that the underlying inflation rate really is, as Furman suggests, 5%. That would be 3% above the target rate. Not trivial, but hardly enough to impose the draconian tightening that Furman is recommending.
Furman continues with, what seems to me, a confused and confusing rationale for monetary tightening.
[Underlying inflation is] a product of extremely tight labor markets leading to rapid wage gains that passed [sic] through as higher prices. These higher prices have also led to faster wage gains. Some call it a “wage-price spiral,” but a better term is “wage-price persistence,” because inflation stays high even after the demand surge goes away.
This passage is beset by confusions, explicit or implied, that require unpacking. Having started with a correct observation that the economy’s “underlying inflation had nothing to do” with increases in any particular price or set of prices, Furman contradicts himself, attributing inflation to “rapid wage gains” that got passed through “as higher prices,” which, in turn, led to “faster wage gains.” That this ancient fallacy about the cause of inflation would be repeated by a former CEA chair, now a professor of economic policy at the Kennedy School at Harvard, is, well, dispiriting.
What’s the fallacy? An increase in one price – presumably, including the wage paid to labor — can never explain an increase in prices in general. To suggest otherwise is to commit the “fallacy of composition,” or something closes to it. (See “Fallacy of Composition”) An increase in wages relative to other prices could just as well be associated by wages remaining constant and all other prices falling; there is no logical necessity for wage increases to entail increases in other prices.
Of course, Furman might not be asserting a logical connection between wage increases and price increases. He might just be making an empirical observation that it was rising wages that initiated a series of price increases and an unending process of reciprocal wage and price increases. But even if wage increases did induce subsequent increases in other prices, that observation can’t account for an inflationary process in which wages and prices keep rising endlessly.
To account for such a continuing process, an explanation of why the process doesn’t eventually reach an endpoint is needed, but missing. There must be something that enables the inflationary process to conintue. That additional factor is, of course, the monetary or macroeconomic environment that determines aggregate demand and aggregate spending. Furman obviously believes that the process can be halted by monetary or macroeconomic policy measures, but, focused solely on wages, he ignores the role of policy in initiating and maintaining the process.
Other, related, confusions emerge in Furman’s next paragraph.
Wage growth is currently running at an annual rate of about 5%. Sustaining such wage growth with 2% inflation would require a large increase in productivity growth or continually falling profit margins. I’d root for either outcome, but I wouldn’t bet on them. Falling wage growth could bring down inflation, but in an economy with nearly two job openings for every person looking for work, don’t expect it to happen. Instead, the most probable outcome is that if the unemployment rate doesn’t rise, wages will continue to grow at that pace, which historically is associated with about 4% inflation.
In a previously quoted passage, Furman asserted that wage increases caused underlying inflation. But that was not what actually happened in the current episode. Since January 2021, just before the current inflation started, prices started rising before wages, and until the last six months or so prices have been rising faster than wages, causing real wages (i.e. adjusted for the purchasing power) to fall.
It’s one thing to say that wage increases cause the prices of things made by workers to increase; it’s quite another to say that wage increases cause the price of the things made by workers to increase faster than wages increase. By blaming current inflation on the current increase in wages, Furman is, in effect, calling for permanent real-wage cuts. Since wage increases cause “inflation persistence,” Furman proposes a restrictive monetary policy to reduce the overall demand for labor and the rate of increase in nominal and real wages.
Real wages (adjusted for the CPI) were barely higher in Q4 2022 than in Q4 2019 even though real GDP in Q4 2022 was 5.1% higher than in Q4 2019 and per-capita real GDP was 4.1% higher in Q4 2022 than in Q4 2019. If inflation is (in my view mistakenly) attributed to a distributional struggle that labor is clearly losing, then it’s obvious that it’s not wages that are to blame for inflation.
Furman makes another astonishing claim in the next paragraph.
Monetary policy operates with long and variable lags. Given that most of the tightening in financial conditions was already in place 10 months ago and, if anything, the real economy and demand have strengthened in recent months, it would be foolish to sit and wait for the medicine to work.
How long and variable the lags associated with monetary policy really are is a matter of some uncertainty. What is not uncertain, in Furman’s view, is that most of the tightening had occurred 10 months ago (May 2022). The FOMC began raising the Fed Funds target exactly a year ago in March 2022. How Furman can plausibly assert that most of the effect of the Fed’s tightening were in place 10 months ago is beyond me. The Table below shows that 10 months ago (May 2022) the effective Fed Funds rate (St. Louis Fed) was still only 0.77% and has since risen to 4.57% in Feburary.
Below is another table with the monthly average yield on constant maturity 10-year Treasuries, showing that the yield on 10-year Treasuries rose from 2.13% in March 2022 to 2.90% in May (reflecting expectations that further increases in the Fed Funds rate were likely). But the rate on 10-year Treasuries rose from slightly more than 2% to nearly 4% between March 2022 and October 2022, with rates fluctuating since October in a range between 3.5 and 4%.
So I can’t understand what Furman could was thinking when he asserted that most of the Fed’s tightening of financial conditions were already in place 10 months ago. The real economy has indeed strengthened, but that strengthening reflects the unusual economic circumstances in which both the real economy and monetary policy have been operating for the past three years: the pandemic, the partial shutdown, the monetary and fiscal stimulus, the supply-chain issues that initially obstructed and hobbled the return to full employment even as unemployment was falling to a record low rate of 3.5%.
Dramatic evidence that the effects of the tightening since January had not been fully absorbed by the economy was provided within days after Furman’s op-ed by the failure of SVB and Signature Bank and only days ago by the rescue of Credit Suisse. And there is no assurance that these are the last dominoes to fall in the banking system or that other effects attributable to the increase in rates will not emerge in the near future.
Furman also overlooks the permanent withdrawal of workers (mostly but exclusively babyboomers nearing retirement age) from the labor force during the pandemic. Despite a rapid decrease in unemployment (and increase in employment) since the summer of 2020, and total employment in February 2023 exceeded total employment in 2020 by only 1.9%. The labor-force participation rate has dropped from 63.3% in February 2020 to 62.5% in February 2023.
With fewer workers available as businesses were responding to increasing demand for their products, competition to hire new workers to replace those that left the labor force is hardly surprising. However, a largely transitory burst of inflation in the second half of 2021 and the first half of 2022 outpaced a perfectly normal increase in nominal wages, causing real wages to fall. But it would be shocking – and suspicious — if normally functioning market forces didn’t drive up nominal wages sufficiently to cause a real wages to recover given the increased tightness of labor markets after a significant negative labor-supply shock.
For Furman to suggest that a market adjustment to a labor-supply shock causing an excess demand for labor should be counteracted by tight monetary policy to reduce the derived demand for labor is extraordinary. There may be – and I believe that there are — good reasons for monetary to aim to bring down the growth of nominal spending from roughly 7% to about 5%. But those reasons have nothing to do with targeting either nominal or real wages.
In fact, lags are precisely why the Fed should do more now—considering it will take months for whatever the central bank does next to have a meaningful effect on inflation.
Furman seems to envision a process whereby wage increases are necessarily inflationary unless the Fed acts to suppress the demand for labor. That is not how inflation works. Inflation depends on aggregate spending and aggregate income, which is what monetary and macroeconomic policy can control. To subordinate monetary policy to some target rate of increase in wages is a distraction, and it is folly to think that, with real wages still below their level two years ago, it is the job of monetary policy to suppress wage increases.
Last week I reposted a revised version of a blogpost from last November, which was a revised section from my paper “Between Walras and Marshall: Menger’s Third Way.” That paper was presented at a conference in September 2021 marking the 100th anniversary of Menger’s death. I have now completed my revision of the entire paper, and the new version is now posted on SSRN.
Here is the link to the new version, and here is the abstract of the paper:
Neoclassical economics is bifurcated between Marshall’s partial-equilibrium and Walras’s general-equilibrium. Neoclassical theory having failed to explain the Great Depression, Keynes proposed a theory of involuntary unemployment, later subsumed under the neoclassical synthesis of Keynesian and Walrasian theories. Lacking suitable microfoundations, that synthesis collapsed. But Walrasian theory provides no account of how equilibrium is achieved. Marshallian partial-equilibrium analysis offered a more plausible account of how general equilibrium is reached. But presuming that all markets, but the one being analyzed, are already in equilibrium, Marshallian partial equilibrium, like Walrasian general equilibrium, begs the question of how equilibrium is attained. A Mengerian approach to circumvent this conceptual impasse, relying in part on a critique of Franklin Fisher’s analysis of the stability of general equilibrium, is proposed.
Commnets, criticisms and suggestions are welcomed and encouraged.
I have just submitted the paper to the European Journal of the History of Economic Thought. The updated version is not substantively different from the previous version, but I have cut some marginally relevant material and made what I hope are editorial improvements. Here’s a link to the new version.
Any comments, questions, criticisms or suggestions would be greatly appreciated.
I hope to post a revised version of my paper “Between Walras and Marshall: Menger’s Third Way” on SSRN within the next week or two. In my previous post I copied a revision of the section on Franklin Fisher’s important book Disequilibrium Foundations of Equilibrium Economics.
I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey’s unduly neglected contributions to the attention of a wider audience.
Uneasy Money 